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.