Month: May 2018

InnOvation Capital & Management, LLC

IntelDigest

LAW – POLICY – FINANCE – MARKETS
INFORMATION FOR THE ENTERPRISE AND INVESTOR

MAY 30, 2018

 

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.

 

We have begun to take a  Look Ahead  at the Economy-To-Come in recent issues of  IntelDigest … planning for the transition from Bull to Bear.

We expect high volatility in the markets as we go into August and September, so we want to prune the most volatile stocks from portfolios before August … trying to sell into strength by mid-Summer.

And, we fully expect that the Economy will fall into recession by some time next year, and perhaps result in an extended period of stagnation in the equities markets lasting for at least a few years.  Perhaps, stagnation will roll into a return of the Stagflation  of the 1970s … especially if political pressure is applied.

 

Stagflation

Looking back to 1972 … Richard Nixon was President, ramping up his campaign for re-election that year.  Part of his strategy was keeping the Economy running well through Election Day, so he put significant pressure on Federal Reserve Chairman Arthur Burns to keep interest rates low.

Despite the danger of runaway inflation from such a policy, Burns acquiesced to the President’s “request.”

The inflation resulting from this action and other “easy money” policies of the Federal Reserve came to the fore in the mid-‘70s.  Inflation spiked over 12%.  Interest Rates were catapulted to unheard-of levels (do you remember mortgage rates of 15-16%?).  From 1977 through 1981, the U.S. Dollar lost half of its value.

What are the chances that history repeats itself in the next couple of years, as Donald Trump ramps up his own bid for re-election?

Danger signs of just such an occurrence were revealed in a recent  Politico  interview.  Kevin Warsh … a former governor of the Federal Reserve and a candidate for Chairman before Jerome (Jay) Powell was chosen … spoke on the  Politico Money Podcast  about a meeting with Donald Trump last year in the Oval Office.

“If you think it was a subject upon which he delicately danced around, then you’d be mistaken.  It was certainly top of mind to the president,” Warsh said about Trump’s questioning on interest-rate policy.  “The president has a view about asset prices and stock markets.  He has a view based on his long history in his prior life as a developer and real estate mogul of the role of interest rates.”

Warsh added that he did not have the impression that Trump viewed the central bank as an independent organization meant to make decisions in the best long-term interests of the economy rather than at the bidding of the White House or any other political institution.  “In some sense, the broader notion of an independent agency, that’s probably not an obvious feature to the president,” he said.

Asked if the president appeared to understand the historical importance of the Fed’s independence from partisan political pressure, Warsh said:  “This might be a good time for a no comment.”

The interviewer, Ben White of  Politico, summarized the discussion:

“The fear is that Trump pressures [Fed Chairman] Jay Powell to keep rates low even if it means higher inflation … We are now entering a new age of explicit political pressure on the Fed to keep interest rates low.”

There is no urgency regarding Interest Rates at the moment, as the Economy has been going through a period of expansion and Markets have been strong.  The stated policy of The Fed is to increase short-term rates gradually, from the current level of 1.75% to 3.25% by early 2020.

A likely scenario is that the next Recession will be upon us before The Fed reaches that target.  When the Recession hits, stock prices of many companies will slide, and could see their values cut in half.

At that point, political pressure from the White House to cut interest rates will be overwhelming.  The combination of:  (1) tight labor markets,  (2) federal government deficits of A Trillion Dollars per year,  (3) the still-bloated balance sheet of The Federal Reserve, and  (4) Interest Rate Cuts … would likely bring on 1970s-style  Stagflation.

 

The Unraveling

We have written about the coming Unraveling of the Bull Market, and some of the causes.  One viewpoint on the Markets is that we are turning a corner on Valuations.

Up to this point … and for the last two years … we have been writing that we were unconcerned that stock prices were soaring.  Even with stocks at historically nose-bleed levels, we did not see them as overvalued, primarily because Interest Rates were at abnormally-low levels.

However, we are turning the corner … costs are rising, interest rates are increasing (gradually), and economic growth/expansion will not support further acceleration of stock values.  Here are a few areas where corporate profits will be pressured over the next couple of years, which will act to deflate the valuation balloon:

* Commodity Prices Rising … grain and feedstocks, lumber, steel, and many other commodities

* Labor Costs Growing

* Trucking/Transportation Costs Exploding … on all goods

* Strengthening U.S. Dollar … weighs on U.S. trade, especially on the exports of multinational corporations

* Interest Costs Climbing … The Fed raising short-term rates and reducing its balance sheet … The European Central Bank will soon follow as it tapers its own quantitative easing program

* Energy Costs Making New Highs … rising oil prices are a tax on consumption

* Regulatory Threats on Technology/Social Media … Alphabet/Google, Facebook, Twitter, and other companies in this space have to hire thousands of compliance personnel to monitor and supervise the dissemination of personal data, putting a drag on profits

 

Reversion to Mean

Rising costs have been evident in the 1Q earnings reports of most companies, but have been masked by the new federal cuts on corporate tax rates.  Count on future corporate profits and stock valuations being hampered by rising costs.

David Rosenberg, chief economist and strategist at the Gluskin Sheff firm, concludes that valuations have topped out.  He points to admissions by the Federal Reserve Bank of San Francisco that  “Current valuation ratios for households and businesses are high relative to historical benchmarks … We find that the current price-to-earnings ratio predicts approximately zero growth in real equity prices over the next 10 years.”

 

 

InnOvation Capital & Management, LLC

IntelDigest

LAW – POLICY – FINANCE – MARKETS
INFORMATION FOR THE ENTERPRISE AND INVESTOR

MAY 23, 2018

 

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.

 

We have written, at length, on near-term prospects for  The Economy and Markets  in Spring issues of  IntelDigest.  We remain substantially invested in equities, expecting one final upward lurch in this nine-year-old Bull Market.

Last week, we began to move on to a discussion of  The Look Ahead  by replaying our February 21 discourse on  Inflation, Interest Rates, and Volatility.

It is time to begin planning for the transition from Bull to Bear. As we wrote in an earlier issue:

The next few months will likely be the last opportunity for growth in equities for the next several years.  So, we face a balancing act in the near-term … how to find and secure growth prospects while the “Melt Up” in equities plays out its last few months … and when to get out with our gains before the market begins its slide into recession.

We expect high volatility in the markets as we go into August and September, so we want to prune the most volatile stocks from portfolios before August.  As we expect the markets to stay strong in the next few weeks, we’ll try to sell into strength before mid-Summer.

 

Select Opportunities

One area where we still see short-term new investment opportunity is small-cap stocks.  Gains in small-caps this year have been four times higher than large-cap stocks, in general; and, this trend is expected to continue through the next two quarters.

Why are small-caps outperforming now?  Smaller companies are likely doing most of their business in the U.S., so they benefit from the strong domestic economy.  And, with mostly domestic operations, they are less vulnerable to a rising U.S. Dollar.  A stronger Dollar makes U.S. goods more expensive for foreign buyers, which is a disadvantage for large multi-nationals doing business overseas.

All American corporations have been given a gift in the form of new Federal corporate income tax cuts.  But, smaller companies tend to be more nimble than large corporations, so they can adjust faster to take advantage of new growth opportunities.

All that being said, investors should be selective about finding companies with good fundamentals and in an Up-Trend.  And, expect to be in and out of such a trade in six months or less.

 

Transitioning to an Era of High Risk

We fully expect that the Economy will fall into recession by some time next year, and perhaps result in an extended period of stagnation in the equities markets lasting for at least a few years.

So, we are constantly reviewing portfolios, and paring back risk.  We expect to have portfolios reduced to the most secure, dividend-producing, “boring” companies by the time that leaves are turning orange and gold.

And, most importantly, we are sticking to our Stop Losses on all investments.   (Stop Losses are set prices or percentages which you use to know exactly when to sell).

This is the most prudent Exit Strategy for 2018.

 

The Unraveling

Among the causes of the Unraveling of the Bull Market will be the actions of the Federal Reserve (Fed).  Even if the Fed were to make NO more raises in short-term interest rates this year, it is on course to remove Hundreds of Billions of Dollars of liquidity from the financial markets.

The Fed followed a policy of Quantitative Easing for several years, where they created liquidity in the battered marketplace after the 2008 Financial Crisis.  Quantitative Easing is an unconventional monetary stratagem in which a central bank purchases government securities, or other securities in the marketplace, in order to lower interest rates and increase the money supply.

Starting late last year, the Fed decided that it was time to reverse the process.  And, its “tightening” of the money supply is now occurring at the same time that the federal government is running ever-greater federal deficits.

The Fed’s unwinding of its massive bond portfolio began on October 1, when it began to allow its balance sheet to “run off” by $10 Billion per month.  This means that, as bonds in its portfolio mature, The Fed will not “roll” the assets into new securities.  The assets are removed from the portfolio, and The Fed Balance Sheet shrinks.

This has continued at a rate of $10 Billion per month in U.S. Treasury securities and $3 Billion per month in mortgage securities.

The immediate effect on the Economy is that prices of short-term U.S. bonds have dropped dramatically, and their yield (interest rate) has climbed dramatically.

The thinning of the Fed Balance Sheet is expected to accelerate throughout 2018.  By the end of the year, close to Half a Trillion Dollars will have disappeared.  That represents a sizeable reduction in demand for both mortgages and U.S. Treasury securities.

In the ordinary course of business, banks and finance companies borrow money at the short-term rate and lend it out at the higher, long-term (usually 10-year) rate.  As long as short-term capital costs less than long-term, the system works and capital markets are liquid.

However, in extraordinary times … such as when a central bank is selling Billions of Dollars of mortgages and Treasury Debt into the market … the system begins to break down.  Short-term rates can rise to match, or even exceed, long-term rates.  As the spread between short-term and long-term rates narrows, it becomes progressively more difficult for banks and mortgage companies to access capital, reducing market liquidity.  The banks cannot profit from lending money

 

Inversions

There is a high likelihood … because of the Fed actions … that we will see a rare “inversion” between short- and long-term rates in 2018 or early 2019.  This is referred to as an “inverted yield curve,” which is a well-known precursor to recession.

In its wake, there would be a dramatic drop in earnings among banks.  We will certainly see an increase in nonperforming loans … a subject which we will address in June in a special issue on Debt.

The next Bear Market and Recession are just over the horizon. No matter how much higher the markets go during the current “Melt Up,” the inevitable downturn will be there in its wake.

 

Over the next few weeks, we’ll discuss Credit Cycles and Stagflation, and re-visit the role of Debt in the Unraveling to come.

 

 

InnOvation Capital & Management, LLC

IntelDigest

LAW – POLICY – FINANCE – MARKETS
INFORMATION FOR THE ENTERPRISE AND INVESTOR

MAY 9, 2018

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.

 

We close out the recent thread on near-term prospects for  The Economy and Markets  in this issue of  IntelDigest.

As we have written in recent weeks, we fully expect that the Economy will fall into recession by some time next year, and perhaps result in an extended period of stagnation in the equities markets lasting for at least a few years.

But, we believe that the next recession is inevitable, not imminent.

Last week, we listed a number of factors which Investment Analyst Louis Navallier has set out to support the proposition that stocks will continue to “Melt Up” for the next few months.

Today, we will discuss valuations and yields, and begin to lay the groundwork for “transitioning” our portfolios to an era of high risk.

 

Valuations

Stock prices have, generally, been on an upward path for nine years.  This has been an unusually long bull market.  And, stock valuations have become unusually pricey … at least, based on historical measures of value.

However, as we have posited in prior issues of  IntelDigest, stocks have NOT been overvalued or overly expensive when Interest Rates are taken into account.  This nine-year time period has been characterized by an ultra-low Interest Rate environment which is totally unprecedented.

Therefore, we are not deterred by the perceived-high valuations as stock prices “Melt Up” in the coming months.

 

Earnings Yield

Yield  is an important component in measuring the valuation of an asset.  Calculating the  Earnings Yield  on a variety of investments allows us to easily compare them.

As an example … if your bank were paying you a yield of 5% on your cash on deposit, you would keep your money in the bank unless riskier assets … such as stocks and bonds … could top that rate of return.  We calculate the Earnings Yield on equities investments by comparing Earnings-per-Share to the Price of a share of the stock.

Looking at the markets at the turn of this century, one could earn a yield of 6-7% on a U.S. Treasury bond.  Meanwhile, the Earnings Yield in the stock market was around 4%.  As a result, many investors in the year 2000 were happy to earn 6% safely in bonds, which was better than a 4% return in riskier stocks

What is the best choice here in 2018, as we near the end of a nine-year bull market?  The Earnings Yield on stocks (around 6%) is double that of Treasury bonds (just under 3%).  Stocks have been a “no-brainer” for several years.

By the beginning of next year, most investors will be jumping to the safety of Treasuries.

 

Near-Term Markets

First Quarter earnings of the largest corporations have been better than expected;  indeed, companies have had an historic 1Q, based on earnings.  However, the response in the markets has been tepid, as the prospect of a recession over the horizon constrains investors.

A few trends can be gleaned from the numbers.  First, the markets are favoring those companies which have posted strong sales and earnings, with strong positive guidance.  Strong earnings aren’t enough.  The forward guidance has had to signal strength in 2Q or 3Q.

Second, companies which have not provided strong forward guidance have seen their stock prices slide for a few days.  But, typically, strong companies saw their stock prices rebound thereafter.

The market actions/reactions illustrate that so much of trading these days is computer-centric, and highly reactive.  As many human market-makers have been replaced by computer algorithms, stock price moves in reaction to news and earnings reports are immediate.  Computers don’t think, they react.

So, investors would be wise to stay calm in the face of frantic market moves, and allow a few days for prices to revert to mean.  If some of your stocks are becoming too volatile, it is worth staying calm, and waiting for opportunities to sell into strength.

 

Where To Go Next

We are making plans for the transition from bull market to bear market.  As we wrote last week:

The next few months will likely be the last opportunity for growth in equities for the next several years.  So, we face a balancing act in the near-term … how to find and secure growth prospects while the “Melt Up” in equities plays out its last few months … and when to get out with our gains before the market begins its slide into recession.

One indicator which we are studying is  The Wedge Pattern. Trading ranges in the equities markets have been getting tighter … as the prices of stocks go up and down over time, the highs are getting progressively lower, and the lows are higher.

On a stock chart, this creates a wedge-shaped pattern.  When the point of the wedge becomes evident, there can be a steep run up in stocks, or a steep dive.  Because economic conditions are currently at the best level in years, and there are still many Billions of Dollars on the sidelines (held by U.S. and foreign investors), we interpret the wedge as pointing to a final blow-out higher in the equities markets this year.

We expect high volatility in the markets as we go into August and September, so we want to prune the most volatile stocks from portfolios before August.  As we expect the markets to stay strong in the next few weeks, we’ll try to sell into strength before mid-Summer.

This doesn’t mean that we are leaving equities entirely.  We expect that strong, “boring,” income-yielding companies can form the basis of one’s portfolio in the coming bear market.

 

Exit Strategy

However, it is important to devise an Exit Strategy for each and every asset in your portfolio.  We recommend establishing a Stop Loss level for each asset;  the Stop Loss is the exit price where you will sell your position if the price drops that low. The Stop Loss can be a specific dollar price, or a percentage loss from the highest price which a stock has attained.

By setting Stop Losses and executing them without emotion, one can methodically cut losses, while allowing winners to ride.

Later in the Spring, we will devote an issue of  IntelDigest  to the subject of  Income Investing  in the coming bear market.

 

 

 

InnOvation Capital & Management, LLC

IntelDigest

LAW – POLICY – FINANCE – MARKETS
INFORMATION FOR THE ENTERPRISE AND INVESTOR

MAY 2, 2018

 

 

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, with discussion of The Economy and Markets.  As in our most recent issue, we continue today to discuss the near-term … what to expect over the next few months.  In later issues, we will go into prospects for 2019 and 2020.

We fully expect that the Economy will fall into recession by some time next year, and perhaps result in an extended period of stagnation in the equities markets.  Such stagnation could last from 2019 through 2022.

It is important to distinguish between the near-term period, which should last through most of 2018, and the recessionary period beginning in 2019.  The next few months will likely be the last opportunity for growth in equities for the next several years.  So, we face a balancing act in the near-term … how to find and secure growth prospects while the “Melt Up” in equities plays out its last few months … and when to get out with our gains before the market begins its slide into recession.

 

 

Noise in the Markets

As we have stated on several occasions, our premise for the remainder of 2018 is that the equities markets will continue to rise, even if increased volatility makes the ride somewhat like a roller coaster.  Speaking of volatility, market opinions are roiling as much as stock prices … ranging from expositions on the continued “Melt Up” of the markets, which we support, to the bearish viewpoint that the markets are in danger of imminent collapse because of Debt and overstretched valuations.

To which we say … the recession is inevitable, not imminent.

We will have much to write in the next few months about Government Debt and Deficits, and Corporate Debt, and Credit Card Debt, and Student Loan Debt, and Auto Loan Debt … and the “unsustainability” of it all.

But, not today.

 

 

Earnings Growth

In our last issue, we wrote about the prospects for First Quarter earnings of the largest corporations;  we quoted estimates from  FactSet  of 17.1% earnings growth for the S&P 500, which would mark the highest growth rate in seven years.

We are approximately half-way through the 1Q earnings announcements, and results have been better than expected.  If the remaining companies reporting in the next week or two beat expectations, this will be a historic quarter.

Under ordinary circumstances, such reports of blockbuster profits and healthy cash flows would result in stock prices exploding upward.  However, the prospect of the Recession Monster over the horizon constrains investors.  So, results have been uneven.

Consider the case of McDonald’s (MCD), which had a blowout First Quarter.  The company reported better-than-expected earnings, better-than-expected revenue, and strong same-store sales growth … 2.9% in the U.S. and 5.5% globally.

As a result, the stock jumped up 6% for the day.  That is a normal market reaction.

However, compare the case of Caterpillar (CAT), which manufactures construction equipment.  CAT beat earnings expectations by 33%!  But, management commented that earnings growth may be “as good as it gets.”

The market took this as a warning and the stock price fell 6%.

 

 

The Best Game in Town

Investment analyst Louis Navallier still calls the current uneven equities markets the “best game in town.”  He offers several reasons to support continued growth in the markets and the economy at-large:

1. Although some big-name, big-cap stocks are under pressure right now, and lots of money is being reshuffled on Wall Street, it is a healthy sign that money is NOT leaving the stock market, but is merely being redistributed to other equities, especially dividend growth stocks.

2. Housing is still in an uptrend.  The National Association of Realtors announced that existing home sales rose 1.1% in March to an annual rate of 5.6 million … there is only an ultra-tight 3.6-month supply of existing homes for sale.

Existing home sales will likely continue to be held down by a lack of inventory.  Median home prices have risen 5.8% in the past 12 months to $250,400.  Higher home prices tend to boost consumer confidence.

3. The Conference Board announced that its consumer confidence index rose to 128.7 in April, up from a revised 127 in March and down slightly from a 17-year high of 130 back in February … improving consumer confidence bodes well for strong retail sales, which naturally tend to pick up as the weather improves.  So, the second-quarter GDP growth is off to a good start.

4. The Commerce Department reported that the trade deficit in March declined by 10.3% to $68 Billion – the first decline in seven months and substantially below economists’ consensus estimate of $73.4 Billion.

5. Gross Domestic Product (GDP) improved in the First Quarter, with the Commerce Department estimate coming in at annual growth of 2.3%, above economists’ consensus estimate of 2%. Consumer spending expanded by only 1.1% in the first quarter, but business spending expanded at a robust pace as spending on equipment rose 6.1% and structures soared 12.3%.

6. The Commerce Department also reported that the Fed’s favorite inflation indicator, the Personal Consumption Expenditure (PCE) index, rose 1.8% in the past 12 months. Therefore, the Federal Reserve is now more likely to raise short-term interest rates at the June FOMC meeting, and perhaps twice later in the year, if inflation persists.

7. Finally, the U.S. Dollar has regained strength after a rocky few months.  A stronger U.S. Dollar should help to keep commodity prices down for a few more months, as most commodities are priced in Dollars.  Additionally, foreign investors are now more likely to buy Treasury securities in a stronger U.S. Dollar environment.

 

 

Strategy for Careful Investing in 2018

This could become the Year of Investing Dangerously.  So, we should all be preparing exit strategies for our portfolios, and treading very carefully with respect to new investment over the remainder of this year.

The best approach to investing in these last months of the “Melt Up” starts with a few simple questions.  Before going into any new stock investment this year, be sure that the company has qualities which will help it to thrive in Up markets, and withstand the pressures of a coming recessionary environment:

1. Is this company strong enough to survive a recession?

2. Are its products/services popular across segments of society?

3. Does it have obvious advantages over competitors?

4. Do people queue up for its products/services, either online or at brick-and-mortar locations?