2019 Q3

The third quarter brought a lot of movement in the domestic stock market but by September 30th the S&P 500 had not gone far from where it started the quarter. Geopolitical concerns continue to create a lot of uncertainty.  In the Q2 commentary, we mentioned the smoothing of trade negotiations between the US and China.  About 27 seconds after we hit “print,” President Trump announced the whole thing was falling apart.  This, along with Brexit drama, recession expectations and slowing corporate earnings growth, appear to have the market’s mood moving from cautious optimism to slight pessimism. 

Economically, the US and global economies continue to show signs of slowing.  Many countries across the globe are teetering on the edge of recession, defined as two consecutive quarters of GDP contraction.  Germany and the UK experienced economic contraction in the 2nd quarter.  Italy is also hanging on by a thread.  On the other side of the Atlantic, Mexico and Brazil both contracted in the first quarter and narrowly grew in the second quarter.  Checking in with the other hemisphere, Singapore and South Korea each had a quarter in the first half of the year where their respective economies contracted.   The slowdown in Chinese economic growth is also evident.  

Back at home, economic data is rosier but still pointing to a slowdown.  The US consumer is pulling their economic weight (almost 70% of US GDP) with continued strong spending.  In contrast, production and manufacturing activity both fell in the first and second quarter and the trend is expected to continue when Q3 numbers are reported.  With portions of the economy in a recession, it is reasonable to expect the rest to eventually follow.  That said, the strength of the US consumer – whose spending makes up 67% of GDP – will likely keep us out of recession territory for at least the next couple of quarters.   

Where’s the Value and Why it Matters

As we approach the turn of the economic cycle, we are continually reviewing portfolios to assess risk while we scour the financial markets for value.  Domestically, depending on what valuation metric is used, the US market is anywhere from slightly overvalued to highly overvalued.  If corporate earnings continue to fall, market valuations will become richer until the stock market reacts to the downside.  Looking internationally, European markets are also highly valued but not as much as the US.  That does not necessarily make them a better buy…they have a lot more fundamental issues than US markets. When we survey the entire world, though, the best value continues to be in emerging markets.  Admittedly, we have argued this position for some time (and we will argue a little more later in the commentary). We have also allocated our portfolios, in part, based on this position. 

Why pay so much attention to valuations?  Current valuation tends to be one of the largest determinates of market performance.  Increases in the price of a stock (and cumulatively, the stock market) happen for several reasons.  One is the performance of the company.  In the most basic terms, if a company manages to increase their revenue and their profits, the value of the company increases.  The other big factor is an increase in the price investors are willing to pay for those profits.  This measurement is called the Price to Earnings ratio (PE).  We have referenced this ratio many times over the years…let’s take a deeper dive into what it is and why it so important to consider.

Imagine you are a kid looking to get into the lemonade stand business.  You don’t want to start this lemonade stand from scratch (but of course the lemonade will be made from scratch…you can’t run a proper lemonade stand with Country Time) so you start looking at lemonade stands to buy.  After days of beating the streets on your bicycle performing due diligence on the local stands you narrow it down to two.  They are both perfect…on busy streets with lots of foot traffic, nice table set-up, a great chair to sit in and located under a shade tree.  There is only one difference.  The first makes $50 per day; the second makes $30 per day. 

You approach the owner of the $50/day stand and the young lady there says she’ll sell it to you for $1,000.  Next, you go the $30/day stand to talk to that kid.  He says he’ll sell it you for $270.  How do you determine which one is the better buy?  The most basic way is to look at the price of the stand relative to what it earns (Price-to-Earnings).   The owner of the first stand is asking 20x daily earnings for the stand: $50 x 20 = $1,000. The other owner is asking 9x daily earnings: $30 x 9 = $270.  Which is the better deal?  The second stand because at 9x vs 20x you can buy the second at a lower multiple of earnings.  Another way to think about this: it will take you 9 days to earn your $270 back on the second stand and 20 days to earn your $1,000 back on the first (lemonade stand season is short…that 11 days makes a big difference).  So you shell out your $270 and you’re in business.  

Our lemonade stand transaction is a simplified example of what happens in the stock market.  Just as the two lemonade stands were selling at different price to earnings (PE) multiples, individual securities sell at varying PE multiples and, cumulatively, varying stock markets (Dow vs S&P vs Emerging Markets vs Europe, etc) trade at different PE multiples.  Recognizing this is important because if an investor buys an investment at a lower PE their likelihood of making money through a phenomenon called Multiple Expansion increases. Multiples expansion occurs when the PE investors are willing to pay for a stock increases. Below is a basic example from John Neff’s book, On Investing.  Mr. Neff was the manager of the Vanguard Windsor Fund for over 30 years.  He had incredible success through his career, out-performing the S&P 500 by over 3% per year.   

In his example, he shows, with very basic math, why the price paid for an investment is critical.  His example has two identical scenarios

Static P/E Expanding P/E
Current Earnings Per Share $2.00 $2.00
Current Market Price $26.00 $16.00
Current Price/Earnings 13:1 8:1
Expected Earnings $2.22 $2.22
New P/E 13:1 11:11
New Market Price $28.86 $24.42
Appreciation 11% 53%

– same current earnings and same expected earnings – except for the price you pay for the stock.  His example demonstrates what happens to investment returns when you buy a stock at a lower PE and then the stock later trades at a higher PE.  The performance of the company is the same but when you purchase it at a lower PE it has more room for price appreciation.  In this example, a lot more room. 

So, that’s a nice example but how much does this come into play in actual market returns?  A lot.  In every bull market since 1900, multiple expansion has contributed over 50% of the total price growth of the stock market.  For example, from 1982 to 1999 the PE investors were paying for the market went from 9x earnings to 30x earnings.  This multiple expansion accounted for 52% of the price growth of the market during that time.[i]  But multiple expansion is a finite source of return. In each historical case, the market hit a point when it recognized that price increases based on further multiple expansion no longer made sense.  Think back to lemonade stand…you paid 9x earnings, $270, for the stand.  Would you have paid 20x at $500?  What if it was 30x at $900?  There will come a point, if you are not already there, where you will say, nope…that’s too much.  Investors essentially do the same thing with the market.

That is why there has been a strong correlation between the current market PE and future returns.  Historically, when the aggregate PE of the stock market is high, relative to its historical average, future returns for the following several years are lower relative than when current PE is low (yes, I have data to support this but I’m trying not to turn this into a journal article[ii]).  The reason? PE’s tend to be mean reverting. When there’s a triggering event that draws investors’ attention to high PE’s they start selling, they sell past the average PE to a low PE where the market eventually bottoms. 

GMO, a large institutional investor, maintains a 7-year Asset Class Real Return Forecast based, in part, on this concept of mean reverting PE’s. They look at current market values, make some estimations regarding future growth rates of earnings and profit margins and then come up with an expected return for each market.  Below is their most recent forecast.

The chart has a large spread between their expected performance of US Large Cap stocks and Emerging/Emerging Market Value stocks.  Most of this spread is due to the difference in current day valuations.  Over the last couple of years (2018 and 2019 year-to-date), Emerging Markets have continued to under-perform relative to domestic equities.  Earnings growth has been good but they have not had the returns from multiple expansion that domestic equities have received.  This has resulted in a large value discrepancy between Emerging Markets and Developed Markets.  Emerging Markets growth stocks have not been this cheap relative to US Growth stocks since 2002 (see chart below). 

In the 5 years following 2002, Emerging Markets out-performed domestic markets by a wide margin.  Will history repeat itself?  It’s impossible to say.  Remember the old Danish proverb: Making predictions is hard, especially about the future.  But there are a couple take-aways from the facts: First, domestic equities are facing heavy headwinds.  If return from multiple expansion is tapped out, or nearly so, the market will need to rely on revenue earnings growth and profit margin increases for return inspiring performance.  Not a very promising prospect when the economy is staring down a recession and profit margins (also mean-reverting) are close to an all-time high.  Second, it means domestic equities have a lot more room for multiple contraction.  In other words, in a bear market, they arguably have farther to fall.  Even though Emerging Markets are viewed as the riskier investment, right now, they may not be.    

In the late stages of bull market cycle, which is where we believe we are, is a time when few investors are looking at fundamentals for investment decisions.  The places where assets are over-priced are often the ones that get the most attention (becoming more over-priced) and the ones that are priced remain unfavored until some event – usually not a good one -makes people look around. When that happens, an old investing adage becomes topical again: Valuations don’t matter until they do and when they do, they are the only thing that matters.  We will continue to look for opportunities to invest capital at an acceptable level of risk.


[i] Active Value Investing: Making Money in Range-Bound Markets by Vitaliy N. Katsenelson, page 55 for data through 2005.

[ii] Ibid, page 53 for data through 2005.

2019 Q2

The resilience of the US Stock Market continued in the 2nd quarter.  The economy is still growing, although more signs of a slowdown are appearing.  Due to some good posturing, Q1 corporate earnings did “surprise to the upside,”, but corporate earnings growth did slow, as we speculated in our Q1 commentary.  The slowdown in earnings is expected to continue as corporation report Q2 earnings. There was also some progress, or at least lack of regress, in the trade war between US and China.  At the G20 conference on June 30th, Presidents Trump and Xi agreed to continue disagreeing on friendly terms (without additional tariffs).  There’s no trade deal yet but the two fighters have returned to their corners…for now. 

The stock market and bond market continue to flash conflicting views on the economy.  The stock market points to continued growth; the flattening/inverting yield curve, to a recession. These conflicting views are not necessarily surprising.  An inverted yield curve typically occurs months before a recession (it’s happened with no recession as well), while the stock market tends to make huge gains in the lead-up.  In other words, the inverted yield curve is usually the guy who shows up early to the party, while the stock market tends to be the one who shows up late and surprised to learn there is a party. 

Market sentiment does feel strange right now.  Typically, an over-optimistic, sanguine sentiment presides late in the market cycle as the gains make their final push into an economic slowdown.  If we are in the stage of the cycle we think we are, this is usually when the money that’s been sitting on the sideline for years is dumped in but there has not been a lot flow into domestic mutual funds and ETFs so far this year.  The flow is positive but not by much.  Where is the money coming from that’s pushing the market so much higher?  A large contributor appears to be Corporate Share repurchase programs.

Corporate Share Repurchases

A share repurchase program is when a company utilizes capital (cash) to purchase their own shares, thus removing shares from circulation.  In 2018, corporations – in the S&P 500 – purchased over $800 billion of their own shares.  That set a record.  In fact, it blew past the old record.  According to Goldman Sachs, corporations will set yet another record in 2019[1].  This represents a huge transfer of capital into the markets.  If the Goldman Sachs estimate is correct, by the end of 2019, $1.7 trillion dollars will have been pumped into the stock market in two years.  Seems like a lot of money, right?  It represents almost 7% of the total value of the S&P 500.  It’s a lot of money.

Share buy-backs can be an effective tool to return money to shareholders, because they are more tax efficient than dividends.  Presuming the seller of the stock had a gain and held the stock in a taxable account, they would owe capital gains tax as opposed to the ordinary income tax they would owe on a dividend.  There are also benefits to the remaining shareholders.  Reducing the number of outstanding shares increases the percentage ownership of the remaining shareholders.  For example, if I own 10 shares of a company that has 100 total shares outstanding, I own 10% of the company (whew…that was hard math).  If the company purchases 50 of the outstanding 100 shares but I hold on to my 10, I am now the proud owner of 20% of the company.  That should make my shares a whole lot more valuable.  What a deal.  This is functionally what we see happening in the markets right now.  Companies are buying back their shares in record numbers, increasing their shareholders’ relative ownership.   

The potential benefits of share buy-backs cannot be argued against, but there are some troubling aspects of the current bonanza (to steal the technical term from the graph above).  For starters, what happens to markets when companies reduce their buy-back programs? If the folks over at Goldman Sachs are correct (and why would we ever think otherwise), these repurchases will go on for some time, but they won’t last forever. Data suggests that the capital for these repurchases has come from two main sources.  The first is additional debt.  In our 2018 Q4 commentary we commented on the US Corporate Debt Binge that has occurred over the last 10 years.  A lot of this additional debt appears to have funded share buy-backs.  This is somewhat speculation.  It is difficult to directly connect that these borrowed dollars went to purchase shares.  But when you examine the data of newly issued debt along with data on how capital was deployed, the connection is hard to deny.  Jeffrey Gundlach, the currently anointed “Bond King”, claims the two are related[2].  If anyone would have a “feel” for where the capital has come from and where it is going, I think it would be him.

The second source of capital for buy-backs is repatriation of corporate dollars held overseas.  Over the last several years, companies have accumulated large accounts overseas as a tax shelter against higher American corporate tax rates.  In many cases, companies were borrowing money to finance operations as opposed to bringing it into the US.  To encourage the repatriation of this money, the recent tax code revision featured a special rate for repatriated dollars.  The idea was for companies to use this money to invest in their business and grow the economy.  A lot of it appears to have gone to share buy-backs instead (this does not necessarily mean the money does not go to grow the economy…see Jamie Dimon’s comments below).  

What these two sources have in common is they are kind of one-shot deals.  Corporations can only access so much debt.  While repatriated dollars are a result of earnings, the volume is high because it was built up over years.  These one-shot deals have likely been huge contributors to positive market performance the last two years.  Markets go up when there are more dollars looking to buy than there are owners looking to sell.  In the last two years, corporations appear to have been the overwhelming net buyers.  What happens when that money slows down?  Will that bring about the turn of this extraordinarily long bull market?  Maybe.  It will certainly have an effect. How much is hard to tell.   

Impaired Corporate Performance?

Another concern to consider is how these share buy-backs will impact corporations’ revenue and earnings going forward.  There is always an opportunity cost when deploying capital. In the case of share buy-backs, companies may be missing an opportunity to improve their balance sheet or invest in future growth. CEOs are responsible for making these “capital allocation decisions”…how best to use cash to increase shareholder value.  In his most recent annual report, JP Morgan’s Jamie Dimon spent a couple of paragraphs on buy-backs, specifically on what circumstances need to exist for him to consider buying back JP Morgan stock.  Here’s what he had to say:

We much prefer to use our capital to grow than to buy back stock. We believe buying back stock should be considered only when either we cannot invest (sometimes as a result of regulatory policies) or we are generating excess capital that we do not expect to use in the next few years. Buybacks should not be done at the expense of investing appropriately in our company. Investing for the future should come first, and at JPMorgan Chase, it does.

However, when you cannot see a clear use for your excess capital over the short term, buying back stock is an important capital tool – as long as you are buying it back at a reasonable price. And when companies buy back stock (which we only do when it is at a price that we think adds value to our remaining shareholders), the capital is redistributed to investors who can put it to good use elsewhere. It does not disappear. We currently have excess capital, but we hope in the future to be able to invest more of it to grow our businesses.

In his view, stock repurchases are almost a measure of last resort.  It’s a good tool when there are not enough opportunities to invest excess capital into the growth of the business.  But as pointed out above, a lot of companies are not using excess capital.  They are financing the purchases with debt.  While it provides the immediate satisfaction of increasing the coveted and overly reported Earnings Per Share metric, it does not help the company in the long term.  The borrowed money comes at a cost (interest) and will have to eventually be paid back.  Debt should be used to finance growth, not engineer accounting.  The former can be responsible management; the latter is short-term thinking at its finest. 

Also, as Mr. Dimon points out, if a company is going to repurchase shares, they need to do it when they can get a good price, which makes us question the timing of current purchases.  To create shareholder value with buy-backs, CEOs should execute the programs when their stock is cheap. In his book, Creating Shareholder Value, Alfred Rappaport gave the opinion that repurchasing fairly priced stock added no value to shareholders, and buying overpriced stock would destroy shareholder value over a long period of time.  Opinions may differ as to whether stocks are currently expensive, but I don’t think you will find many people arguing that they are cheap.  If they are expensive, then corporations may be participating in the greatest destruction of shareholder value in history. 

You might think, hey, these are CEOs, really smart people who would not make such a bad decision.  It may be true that they are smart but that does not mean they are good at capital allocation.  William N. Thorndike wrote a book, The Outsiders, where he chronicled the decisions of successful CEOs.  In the first couple of chapters, he draws from some of Warren Buffet’s writings to make the points that one, in rising through the ranks of business, CEOs may have never had to make capital allocation decisions, and two, CEOs are as subject to “groupthink” as anyone else.  With little to no experience with deciding how to invest money and under peer pressure to look like other CEOs, the fact they are overpaying for their stock is not necessarily surprising.  In fact, it may be typical.  The last time buy-backs were north of $600 billion was in 2007, when the market was reaching its peak.  To be fair, this does make some sense.  Corporations will have the most amount of cash towards the end of an economic cycle, but they are not forced to use the cash for share repurchases.  I would rather have my corporations hang on to their cash, or even pay down debt, until they find good investment opportunities. 

Having used up cash and increased leverage, these share buy-backs have likely put corporations in a position where they won’t be able to weather storms or be as prepared to invest when the economy troughs.  It puts another strike against the current corporate health and, to us, further emphasizes the need to be mindful of company balance sheets.  We will continue to look for opportunities to invest capital at an acceptable level of risk.


[1] https://www.ft.com/content/19435b4e-6c2f-11e9-80c7-60ee53e6681d

[2] https://finance.yahoo.com/news/corporate-stock-buybacks-rise-schumer-sanders-172223775.html

2019 Q1

If you were looking for a little encouragement after a volatile December, the 1st quarter did not disappoint.  Global markets strongly bounced back, clocking in gains that would be considered good for an entire year.  Chinese Equity Markets and the Emerging Markets Index posted double digit gains. Likewise, the S&P 500 Index had its best quarter since 1998.  While recoveries like this are encouraging, it’s best to temper our excitement.  With the economy still humming along and corporations still making money, a quick bounce in the market is not surprising.  That said, the real test for the global markets may be lurking somewhere around the corner.  Global economic growth is beginning to look tenuous and US corporate profit increases are expected to decline over the next year.  If the signals are accurate, we should expect more market volatility as the mood swings from worry over economic and corporate data to jubilation from an accommodating Federal Reserve.   

The Fed vs. Corporate Earnings

We witnessed this mood swing during the first quarter.  For the last few years, the Fed has steadily increased interest rates and planned to do so at least 3 more times in 2019.  Over the same period, they reduced the size of their balance sheet.  Both policies are intended to remove money from the financial system, so the economy does not overheat (think housing in 2006 and internet stocks in 1999).  However, the Fed risks dampening natural economic growth if they remove too much money too quickly.  In our 2018 Q4 letter, we speculated that economic data would suggest the economy was weakening and, consequently, the Fed would pause the rate increases earlier than planned to not dampen natural economic growth.  In March, citing weakening economic data, that’s what they did…no more rate increases or balance sheet reductions in the foreseeable future.  The market was in a glass-half-full kind of mood and rejoiced about the accommodative Fed in the face of a weakening economy.  

As the year progresses, corporate earnings may sober the markets mood.  Each quarter, during earnings season, corporations report their financial results.  These reports include public conference calls featuring C-suite executives who explain the results and answer analyst’s questions.  Slide decks are produced to provide colorful visuals on how the company performed (or perhaps distract from how the company performed).  The results often have huge impacts on a company’s stock price.  If a company blows past their “expected earnings,” the stock may jump in price.  If they don’t hit their target, the price can tank. The entire process is a bit nonsensical.  It encourages executives and investors alike to think on a short-term basis (bad idea for both) and sets up a strange expectation setting game as companies “adjust” their estimates so actual earnings will surprise to the upside.  

In any case, the game is on and corporations have started to set investor expectations for lower earnings.  One of the most telling warnings came from Federal Express.  Given their global reach and the nature of their business (they ship stuff, but I’m guessing you knew that), FedEx’s revenues tend to be a leading indicator on the direction of the global economy.  In their most recent earnings call, the CEO and CFO both expressed concerns over the global economy and reduced their earnings guidance for the remainder of 2019.  FedEx is not alone in projecting lower earnings.  S&P 500 companies are expecting an aggregate drop of 4% in earnings from 2018 Q1. 

It would not be a surprise if reported results end up beating expectations…that is part of the game. But even if companies do beat expectations, their profit growth will likely be slowing.  If that trend does play out and earnings continue to slow, one of two things will happen: either the markets will cool or valuations will become stretched as profits decrease and stock prices increase.    

Now…where’s that recession everyone is talking about?

In our 2017 Q4 commentary, we considered where the US economy was in the economic cycle.  We speculated that we were near the end of the expansionary period of the cycle and that signs of an economic slowdown would emerge in the first half of this year.  We didn’t make a call for a recession to begin in 2020.  That is beyond our predictive abilities, and everyone else’s despite their best efforts.  We still believe the economy is heading that direction but there is one factor that does give us pause…. everyone sees a recession coming.  It is constantly talked about in the news.   Over the last few months, people who I would never expect to talk economics have brought up the upcoming recession.  It is widely reported and almost universally expected.  Whenever there is consensus in finance, you should always pause to consider the other side.  

If there is one thing this economic and market cycle has reminded us, it is that things can continue for longer than we expect.  Ten years ago, I was reading about how the Japanese economy is a bug in search of a windshield because of its massive governmental debt (210% of GDP).  Since then, the Japanese have increased government debt substantially to over 250% of GDP (in comparison, the US is at 105%) and the bug is still freely flying in the breeze.  Similarly, there have been countless warnings and many books written (I’ve read a few of them) about the collapse of the Chinese economy over the last 10 years. And yet it is still growing at a 6% clip per year.  Everyone thought the European Union was toast in 2011 with the financial ruin of Greece; it wasn’t. Then the same was feared for the other members of the PIIGS acronym (Portugal, Ireland, Italy, Greece, Spain). Then Greece again. Then Brexit. And then Greece again. And now it’s Italy. Again. Through it all the EU continues.  

With these examples in mind, a year and a half from now we might still be talking about the coming recession. We have never had an economy grow so slow for so long.  This economic expansion is now the second longest in US history and, unless things deteriorate very fast, it will become the longest in just a few months.  The other two economic expansions that lasted nearly this long had much higher GDP growth rates.  The 120-month economic expansion in the 1990’s had GDP growth of 3.6%/year.  In the next longest expansion, during the 1960’s, GDP grew at 4.9%/year.  This economic expansion has seen GDP growth of just 2.3%/year.  Economic busts are typically preceded by economic booms but there has been no boom.  It has been a slow, mediocre rise.  With such mediocrity, this economy could grind along at a slow pace for a long time.  

Whether the recession is just around the corner or two years away, we expect the trend in the market to continue to be volatile.  While we could return to the calm experienced in 2017, especially during the summer months, there seem to be too many conflicting themes in the markets for a lasting calm environment.  There are also still unresolved major geopolitical issues – Brexit and the trade war with China, to name two – that continue to contribute to market uncertainty.  Our portfolio is positioned for the peak of the economic and business cycle: a focus on strong balance sheets; avoiding low quality credit; growth positions in transformative technology or rapidly growing industries and economies that should play out in the long term, recession or not.  We will continue to look for opportunities to invest capital at an acceptable level of risk.


2018 Q4

Happy New Year.    Last year while writing the year-end commentary, we were contemplating the Zen-like calm that had taken over the markets.  Nothing could scare investors: rising interest rates…no biggie; potential trade wars…nothing to see here; geo-political conflict with North Korea…why worry?   But we all knew the calm would not last.  In that commentary we wrote: 

We don’t know what the year (2018) will bring.  Our guess is that there will be more volatility in the markets this year.  It is hard to imagine such a calm, steady year being followed up by yet another calm, steady year.  However, just because it is more volatile does not mean it will be worse or better.  But, predictions aside, the most important thing to take from all of this is not to buy into the calm.  It will not last. 

The calm didn’t last.  2018 ended up being a volatile year with almost every major asset class ending the year at losses.  That quote is not meant as a victory lap.  There was nothing prophetical about our prediction.  It was just a recognition of investor behavior.  When markets are serenely calm, we can be certain that things will eventually turn volatile.  People will ignore bad news until suddenly they don’t.  We saw that transition in 2018.  What didn’t scare investors before became unsettling:  rising interest rates, trade wars, slowdown in corporate profit increases, and a potential recession on the horizon.  

What will markets do in 2019?  Every year we ask this question, and every year we give the same answer: we don’t know.  If you’ve been reading this commentary for a while, you know we are not big on market predictions.  “Expert forecasting” is rarely accurate (need I make the accuracy comparison to that of dart-throwing chimpanzees again?).  Last year, 85% of Wall Street banks surveyed by Fortune predicted the S&P 500 would post positive returns in 2018.   Well, that didn’t work out.  Even the banks surveyed who did predict negative returns were still over 200 points off with their projected ending points.  We don’t know why people think they can accurately predict where the markets are going to be at year end.  They crunch the numbers and somehow come up with a target, but they’re almost always wrong.  They ignore the reality that market movements from year to year have very little to do with numbers and almost all to do with investor sentiment. 

While we think predicting asset class returns for a given year is often a fruitless activity, we are confident that one thing will likely happen in 2019: the  economy will continue to slow.  Financial conditions are weakening.  Liquidity has been tight at times during the last few months.  The possibility of a recession is increasing, and indicators point to it starting sometime in 2020.  In the face of the changing conditions, the Federal Reserve is likely to slow their interest rate increases.  If history is any indicator, the markets will cheer the slowing of rate increases, but the applause won’t last long as economic activity continues to slow.  Financial markets will likely continue to exhibit volatility, but this will hopefully produce some opportunities to buy assets at cheaper prices.  Our conclusion is to remain wary of overly rosy predictions and to remain vigilant in allocating capital.  

Good Ol’ Fashioned Debt Binge

As we near the turn of the economic and credit cycles one area we are closely watching – and have been for some time – is corporate debt.  Corporations have two different methods to access financing: sell equity in the business or borrow money.  There is a cost to each method, and any time a corporation goes to financial markets for money, it assesses which market is the better option.  Over the last decade, tax law, the regulatory environment and extremely low interest rates made it very attractive for companies to finance activity through debt.  Corporations responded by going on a debt binge: total corporate debt in the US has gone from about $4.9 trillion in 2007 to over $9 trillion today.  That’s almost a doubling of corporate debt in the last decade. 

Investment Grade:
Speculative Grade (Junk):

As more debt has been taken on, the overall financial condition of US corporations appears to have deteriorated. To the right is Standard & Poor’s credit rating system.  In their infinite wisdom, Standard & Poor’s and their contemporaries—Moody’s and Fitch—grant long term debt (bonds) issued by companies a rating.  This rating is meant to provide an indication of how likely it is for a company to make the scheduled interest payments and eventually re-pay its debt.  The better the rating, the more likely the lender is to get their interest and their money back. Think of the rating scale as an expanded school grading system: AAA is the best, awarded to bonds believed to be the most financially secure; head of the class.  As the chart descends, the quality of the debt decreases; i.e., the likelihood of the interest being paid and the lender getting their money returned goes down; the school drop-out, so to speak. I want to draw your attention to the BBB category.  BBB is the lowest “investment grade” category, just a step above what is “speculative grade,” which is also more affectionately referred to as “junk debt.”  Standard & Poor’s defines BBB as follows: An obligation rated ‘BBB’ exhibits adequate protection parameters.  However, adverse economic conditions or changing circumstances are more likely to lead to a weakened capacity of the obligor to meet its financial commitment on the obligation.  

Why go to lengths to point this out?  Well, because there are a few of these BBB bonds floating around in the financial system.  And by a few, I mean a lot.  And by a lot I mean 50% of all outstanding investment grade bonds…somewhere around $3 trillion.  This is very different than it has been the past.  In 1990, BBB only made up about 25% of the market of investment grade bonds.  Going back to 1980, the median bond rating was A (that’s great!), and now the median is BBB- (not so great).  On average, corporate debt is as poorly rated as it has ever been, but that’s not where the problems end.  When you dig a little deeper, things deteriorate even further: companies rated BBB have almost twice the leverage (what they owe versus what they own) than they did in 2000 (1.7x vs. 2.9x). 

Based on these ratings, overall indebtedness, and leverage multiples it is clear there has been deterioration in the financial condition of the debt market to where almost half of all investment grade corporate debt is with companies who under adverse economic conditions or changing circumstances are more likely to have a weakened capacity to pay their debt.  The terms “adverse economic conditions” and ” changing circumstances” are vague and open to various interpretations. Here are a couple scenarios that may fit those terms: recession and rising interest rates. That interpretation yields the following reality: half of all investment grade corporate debt in the U.S. is likely to have a weakened ability to pay their creditors during a Recession or while Interest Rates are Rising.

Look lower down in credit quality, down in the junk bond portion of the markets, conditions have also grown riskier.   With low interest rates the past ten years, investors sought higher yields.  On Wall Street, there is no such thing as unmet demand.  Collateralized Loan Obligations (CLOs), Speculative Grade loans that are broken apart and then re-bundled with other loans, were sold at a record pace.  These types of loans were typically financed by banks, and the terms of the loan contained covenants – legal parameters that are meant to protect the lender.  Over the last few years, they are increasingly being issued “covenant-lite,” meaning without many of the normal lender protections.  To make the situation more precarious, more of these loans are being financed by non-bank entities who are not as closely regulated as banks.  When lending occurs outside of the banking industry, underwriting standards tend to suffer.  Simply put, junk debt is becoming junkier.  

Given these circumstances, we can see a scenario playing out where a lot of companies struggle under their debt load during a recession.  The cost to finance with debt has been rising over the last couple of years, but it has been outpaced by the high tide of earnings growth in a positive economic environment.  When earnings turn negative during a recession, the tide will wash out, and we will see who is swimming without a bathing suit.  Default ratios will increase among Speculative Grade bonds (they always do during recessions, but we wouldn’t be surprised if defaults rise more than normal), and a lot of these BBB bonds may drop from Investment Grade to Speculative Grade.  If those things happen, there will be a lot volatility and repricing in the debt markets.

As we look ahead to these risks, we will work to structure the debt portion of our portfolio to withstand these shocks and be ready to take advantage of any repricing opportunities.  We will continue to look for opportunities to invest capital at an acceptable level of risk.


Past performance is not a guarantee of future earnings.  Asset allocation does not assure a profit or protect against loss in a declining market.  Blake A. Stanley, CFP® is an Investment Advisor Representative of Legacy Advisory Group, LLC a Registered Investment Advisory Firm.

2018 Q3

Global Trade – Keeping It Brief

The last two commentaries were largely focused on the developing global trade war…which country has said what, who’s threatened who with which tariffs, etc. Trade continues to be the dominating geo-political event moving financial markets, but quite frankly, writing about it is starting to feel like writing the gossip column for a junior high school newspaper (do those even exist anymore?).  If we are tired of writing about it, you are probably tired  of reading about it. So, a quick update, and then we’ll look elsewhere for this commentary: some things have been resolved (Europe and, most recently, Mexico and Canada); others have digressed (China) and will likely deteriorate further. There is your official trade war update from we at Legacy  Advisory Group. And now for something completely different….

Emerging Markets

After two years of strong returns, emerging markets have been on a steady decline since January 26th of this year. Like domestic markets, emerging markets started the year with very strong gains, but then experienced volatility towards the end of January. Emerging markets have continued to be pressured throughout the year by global trade fears (we just can’t get away from it, can we?), a strengthening dollar and rising US interest rates.

While these factors do weigh on emerging markets, we believe their ultimate impact will be small.  For one, US trade pressure has been focused on  China. This is not necessarily bad for other countries’ economies,  especially in  Asia.  As the world’s largest exporter,  China is as much of a competitor to those countries as they are to us, if not more so. The world’s largest consumer placing tariffs specifically on imports from the world’s largest exporter may open opportunities to other countries.

As to the other concerns, a strengthening dollar and rising interest rates (which are highly correlated) have been the cause of volatility in emerging
markets for 20 years now. Emerging markets are one of the few asset classes where investors have a long memory. Whenever interest rates start rising and the dollar begins strengthening, investors’ minds go back to the Asian Financial Crisis in 1997/98. Leading up to the crisis, Asian countries and corporations had acquired large amounts of debt denominated in US Dollars. In order to pay this debt, these countries would first need to convert their currency into dollars. This works out ok, so long as their currency doesn’t weaken relative to  the US dollar.  Towards  the beginning of 1997 that’s  exactly what started happening… their currency weakened relative to the dollar and it became more difficult to pay this debt. As  their  currency weakened, more investors sold the troubled currencies, which only accelerated and accentuated the problem. By the end of 1997 the International Monetary Fund had provided emergency loans to the Philippines, Thailand, Indonesia and South Korea  to  the tune of $1  billion, $17  billion,  $40 billion and $57 billion, respectively.

Not wanting a repeat of that disaster, those countries (and others) made significant adjustments that have made them far more resilient  to  currency market changes. They have since built up large financial reserves denominated mostly in US dollars. Of the four countries listed above, the Philippines has the smallest reserve account, at $77 billion. South Korea’s reserve account is north of $400 billion. These funds can be used  to support  their  currency and provide emergency financing to corporations, if needed. Another adjustment was that these countries now finance more of their debt domestically and denominate it in their currency. A much smaller percentage of their total debt is in US Dollars than it was in  the Asian  Financial  Crisis. Because of these changes, these countries are much better prepared to deal with currency fluctuations.

The health of many emerging market economies is often ignored by investors due to ontology. Ontology is the study of the nature of being, and more specifically, the development of categories within a subject area. Take food groups for example. Somebody somewhere at sometime considered all the properties of various foods, found commonalities among them, came up  with  the groupings  and  then  built  that  food  pyramid  we are all  familiar with. That is ontology, and it is very useful for analysis. The process of categorizing helps us better understand an object as we consider  the properties and characteristics of that object. Once categorized, we can deepen our understanding by looking at one category’s  relationship  to another.  However,  the categorization of an object can have shortfalls that can hurt analysis as well. Going back to our food example, some apparently would argue that by stuffing the breadbasket of the original food pyramid with all things grain, it failed to distinguish that whole grains are healthier than refined grains (I don’t like it either, but it’s true: https://www.hsph.harvard.edu/nutritionsource/mypyramid-problems/ ). Through an inappropriate broadening of application, the pyramid implied that all bread was created equal.

A similar broad application has arguably created the same result in emerging market economies. The “Emerging Markets” moniker was coined in the  early 1980’s by economist Antoine von Agtmael, who worked at the then  International  Finance  Corporation,  an arm of the World  Bank.  His  intent was to encourage investment in countries that were between  poor and  rich and that had  publicly listed securities.  Now there’s a broad  definition for you. And that broad definition continues today.  It is used  to describe  both Kenya, with an average GDP  of $350  per person, and China, with an  average GDP of $5,000 per person, and everything between. There are huge disparities across these countries, but this broad categorization causes investors to generally view all these markets the same. When something goes wrong in one or two emerging market economies, investors act like the canary in the coal mine just dropped dead, and they go rushing for the exits.

This year’s dead canary award goes to Turkey and Argentina (Venezuela gets honorable mention). Both countries  have serious  problems.  They each have inflation in the double digits. Argentina’s inflation  is over of 40%.  Unlike many of the Asian countries listed above, Argentina has continued  to take on large amounts of debt in US Dollars and does not have the reserve funds to combat a weakening currency. This has resulted a massive budget deficit. They recently secured an emergency loan of $57 billion from the IMF to help cover their shortfall. This will only calm fears some, as Argentina has a history of default and restructuring (5 times in the last 50 years). Turkey is only two years removed from a good ol’fashioned military coup d’etat attempt. President Erdogan responded by consolidating power and just recently passed a new constitution  that  basically makes  him king.  He  has bullied their central bank to take an unorthodox approach to monetary policy, which  is arguably causing damage  to the economy.  As these countries have suffered, they have stoked the fear of contagion across emerging market and have driven the whole sector lower.

These two countries are not representative of many of the emerging market economies; rather many of them are far more stable both politically and economically. Plus, the long-term fundamentals have not changed. Virtually every estimate of GDP  growth has emerging markets growing at a faster  rate than developed markets. Emerging markets generally have far less debt than developed markets. Furthermore, almost every developed country has an aging population, which creates a drag on economic growth. At its most basic calculation, GDP growth is workforce  growth  plus  productivity growth. In short, you need more people being more productive. With a shrinking working age population, developed countries will have to rely on productivity growth to grow their economies.

Emerging economies, for the most part, do not face the same headwinds. With growing populations (China being the major exception here… their one child policy was short-sited and will cause a huge demographic drag on the economy starting in the next 15-20 years) and ample opportunities  to  improve productivity, their long-term growth perspectives are better than their developed country counterparts. Lastly, on a more philosophical note, countries classified as emerging markets represent roughly 85% of the world’s population. Many of these people are looking for the exact same thing as the developed world … higher quality of life. I recently ran across a quote from Adam Butler of ReSolve Asset Management that rings accurate: An investment in emerging markets is a bet is on tbe expanding prosperity and innovation of our species.

These markets will continue to have their ups and downs. They will continue to face challenges. They are far from risk free  but  our long-term  conviction in emerging markets remains the same. We have carefully selected funds for our portfolio that will invest consistent with the thoughts above. We believe the long-term opportunity is worth living through the ups and downs. We will diligently continue to look for opportunities to invest capital with an acceptable level of risk.


Past performance is not a guarantee of future earnings. Asset a/location does not assure a profit or protect against loss in a declining market. Blake A. Stanley, CFP® is an Investment Advisor Representative of Legacy Advisory Group, LLC a Registered Investment Advisory Firm.

2018 Q2

Freeish Trade

In the last commentary we made the following comment: 

Will there be a trade war?  In our opinion, it seems unlikely.  Thus far, the Trump administration’s actions regarding almost any policy have been more measured relative to the President’s rhetoric. This trend appears to be continuing with foreign trade.

Well, the trend broke.  A lot has happened since we wrote those words, and a trade war (we’re not quite sure when a trade dispute becomes a trade war, but we’ll roll with it) is looking more likely.  The temporary exemption of the steel and aluminum tariffs granted to Canada, Mexico and the European Union (EU) expired, and the tariffs went into effect.  In response, Canada threatened to impose tariffs on several products, including ketchup, maple syrup and lawn mowers. Mexico imposed tariffs on $3 billion worth of goods, and the EU responded with tariffs against the US on $3.2 billion in goods.  China’s tariffs against the US went into effect on April 2nd, and soon after that, they listed another set of goods—worth $50 billion of imports—that it says it may place tariffs upon.   

Things don’t look to be slowing down either.  $34 billion of the original $50 billion in goods the US outlined as tariffs went into effect on July 6th, with the rest scheduled to go into effect on July 31st.  The US has now floated the idea of a 10% tariff on another $100 billion to $400 billion of Chinese imports.  If enacted those tariffs will become active sometime in September.  The US is also in the process of researching potential tariffs that would impact Europe’s auto industry. 

Trade disputes have continued and probably won’t be stopping anytime.  Yes, the World Trade Organization (WTO) is still out there trying to regulate free trade but let’s face it…the WTO is basically the home owner’s association for world trade…it works as long as everyone is on board, and right now, that’s not the case.  What will bring this all to a close?  President Trump is still looking for a deal, and until some of these countries come to the table with satisfactory offers, this will probably keep going.  

There is room for some countries to make concessions.  President Trump’s main target, China, is a serial offender when it comes to free trade.  China has used tariffs to protect developing markets.  This tactic has been used by almost every developed nation at some time in history, including the US.  Alexander Hamilton argued for the same structure of protectionism in his book, Report in Manufactures.  His argument was that American industry was up against the much more developed industrial countries of England and other European powers, and in order to build the young American economy, tariffs would need to be placed on key industries.  This concept was shelved for a time, later be resurrected by Henry Clay, and then implemented after the Civil War.  By the time the income tax was passed in the early 20th century, tariffs accounted for 90% of the US government finance.  Many European nations adopted similar policies through 19th and 20th centuries. 

But the problem the US – and much of the rest of the world – has with China is not protective tariffs.  In fact, China only imports about $150 billion of US goods.  They “tax” foreign companies through subsidizing certain industries (such as steel and solar, flooding the market with underpriced product) and requiring businesses to partner with Chinese companies if they wish to sell product in China.  Take General Motors, for instance.  They entered the Chinese markets decades ago but were required to be in joint venture with a Chinese company, where General Motors owned 50% or less. Why does China do this? One alleged reason is to steal technology.  They make the GMs of the world partner with their companies so they can learn how to make better cars.  Those processes are then (allegedly of course, wink-wink-nudge-nudge) passed on to other Chinese companies.  And they do this with virtually every industry, not just high-tech ones.  In order for a company to transport powdered milk (baby formula) into China, the company must provide regulators with the ingredients, a detailed explanation of their process, and even curricula vitae and contact info for employees in their R&D department.  While these practices were less harmful when the Chinese economy was still in its infancy, China is now the 2nd largest economy in the world and has a global presence.  These practices make it difficult for companies to compete, not only in China but also globally.  Because of its presence, China has plenty of room to make concessions regarding these practices without giving up too much. 

In the meantime, the estimated impact these tariffs have on GDP growth, both domestically and internationally, are still benign.  Domestic markets have responded by continuing to post gains for the year. More pressure has been placed on foreign markets, which are in negative territory for the year, but that isn’t just due to tariffs. The dollar has been strengthening, and several emerging market economies—Turkey, Argentina, and Brazil—are struggling right now, which tends to drag down the rest of the emerging market sector.   Regardless of the practical impact, tariffs make for good television.  As long as the rhetoric between nations remains the way it is, the “trade war” will continue to dominate the financial news cycle. While the increasing trade tension may eventually cause us to rethink some of our portfolio allocations, we believe long term trends remain the same. We will diligently continue to look for opportunities to invest capital with an acceptable level of risk.


Past performance is not a guarantee of future earnings.  Asset allocation does not assure a profit or protect against loss in a declining market.  Blake A. Stanley, CFP® is an Investment Advisor Representative of Legacy Advisory Group, LLC a Registered Investment Advisory Firm.

2018 Q1

Well, look at that…the market does go both ways.    

2018 started by continuing the calm, steady, upward market climb we have experienced for the last two years.  By the end of January, the S&P had gained 6%.  Then the seemingly unthinkable happened…the market had a bad day and just days later  was in a correction (defined as 10% below the most recent market peak), the first correction since December 2015 – February 2016.  

Why the sudden and violent whiplash?  Hyman Minsky, a 20th century American economist, is remembered for his work on the relationship between stability and instability. He argued that stable environments create unstable environments, we just can’t observe the inherent instability until it is fully born.    When an environment is calm, people are comfortable and assume things will continue as they are.  In market activity, this leads people to ignore risk.  That is essentially what happened in January. 

As we noted in our 2017 Q2 commentary, the volatility index (VIX – the fear gauge, which measures investor’s expectations of future volatility) had been trending lower over the last few years and had reached its lowest point on record.  Hedge fund traders (and Target store managers – Google “Target manager VIX trader”) were taking advantage of this trend by heavily shorting the VIX (betting it would continue to go down).  As the calm continued, more and more funds piled into the trade with many using leverage to increase their returns. This provided the appearance of stability – returns were increasing, the pool of investors was widening, and the sun continued to shine.   

The thing about market parties is they only last so long and they never wind down slowly.  Instead of an organized and calm departure, it’s more like the police showing up at a college frat party…everyone rushes for the exit at once.  When this happens in the markets it results in what traders call a liquidity spiral.  There are more sellers than buyers and as people try to unwind their now losing position they take huge losses.  This is exactly what happened…liquidity dried up across markets, volatility went through the roof, and the stock market went down quickly. 

A liquidity spiral in a market the size of the VIX isn’t going to cause a lot of collateral damage.  It’s like dropping a small stone in a lake…the ripples in the water caused by the stone dissipate quickly (in contrast to what happened with sub-prime housing in 2007…that was dropping a nuclear submarine into a lake).  By the time of this writing, markets have calmed but volatility remains elevated from where it was at the beginning of the year.  We expect this to continue.  With the instability from the VIX shorting trade worked out, markets are now noticing structural issues with both businesses and the economy while also trying to wrap their minds around the introduction of tariffs.  We will briefly look at each of these concerns below.  

Corporate Profits

In our last commentary we talked about how we are likely nearing the top of the market and business cycles.  Evidence of that change is starting to appear.  Over the last few years, the factors that drove corporate profit margins to highs – low interest rates, low inflation rates, low wage growth – are starting to deteriorate: interest rates are going up, which raises borrowing costs; inflation in materials is increasing making it more costly for corporations to build projects; and, low unemployment is creating tighter labor markets, which is slowly driving up wages.  

Tight labor markets and increasing interest rates are signs of a healthy economy but once they start impacting corporate profits it points to a peaking/turning cycle.  Corporations will do what they can to pass the inflationary cost on to their customers.  Housing provides an instructive example.  Inflation in materials – particularly timber – and labor have driven up the cost of building new homes. Up to now, consumers have been willing to pay more to cover the increase. But that can only last so long before consumer habits change.  Once that starts, corporations will be forced to cut profit margins to maintain sales and compete with other players in the market. 

The harder part for corporations to deal with will be rising interest rates.  Corporations have used the low interest rates of the last several years to go on a  debt binge.  According to Standard & Poor’s, 37% of global companies are highly indebted as of 2017.  That’s 5% points higher than in 2007, just before the financial crisis (keep in mind though…in 2007 the debt was concentrated in banks, which is what caused the financial crisis.  Bank balance sheet are, generally, in a better position now).  Most of the debt added by publicly traded corporations appears to have been used to re-purchase their own shares.  While share re-purchases are good for current shareholders, it does nothing to increase revenues.  If interest rates do increase, and companies must refinance at higher rates, their profit margins will be further reduced.  For the first time in years, corporate profits are at a serious risk of declining. 

Trade Wars

Market volatility has been furthered as President Trump has announced tariffs on several industries.  The actual economic impact of the tariffs announced so far is limited.  The planned tariffs against China (as of the end of 2018 Q1…this can change fast) have an estimated impact of a .1% reduction on Chinese economic growth (as measured by Gross Domestic Product).  The industries targeted are ones included in China’s, “Made in China 2025” plan.  China’s announced retaliation tariffs appear to be more politically driven than economic.  Industries impacted by the tariffs are prevalent in congressional districts polling as toss-ups in the coming mid-term election.  Targeted groups include farming – particularly soybeans –  and the pork industry.  Also targeted were industries prevalent in Wisconsin (cranberries) and Kentucky (bourbon), the states of Speaker of the House, Paul Ryan, and the Senate Majority Leader, Mitch McConnell.  None of these industries are vital to US economy and the tariffs against those industries do not pose a national threat to economic growth.  So why the market brouhaha?  The market is concerned that this could be the beginning of a broader trade war.    

The World Trade Organization attempts to fairly regulate world trade.  Virtually every country in the world, except North Korea, Turkmenistan, Eritrea and Greenland, are either members or observers.  As members or observers, they agree to follow rules that limit their ability to squeeze foreign rivals with trade restrictions and they agree to adhere to processes designed to reduce dodgy trade practices.  The President’s first round of tariffs – solar panels and dish washers – utilized WTO measures.  The second round of tariffs – on steel and aluminum – did not.  To enact tariffs on steel and aluminum, the President utilized a section of US law (Section 232 of the Trade Expansion Act of 1962) that allows the President to protect industry in the interest of national defense.  In the eyes of the world community, the President is no longer playing by the rules.  Once he – and subsequently China –  acted outside of the WTO the possibility of an escalating trade war increased. 

Since WWII and the signing of the General Agreement on Tariffs and Trade in 1947 by 23 countries the world has moved closer and closer towards global free trade.  During this time, the world’s economic growth has been extraordinary.  It is hard to determine how much of that growth has been attributable to free trade.  The benefits of free trade are theoretical (e.g., the theory of comparative advantage…David Ricardo, a 19th century Englishman) but the logic behind the theory is sound and it is hard to argue with the results. If the world were to regress to a system of protectionism and widespread trade wars, global economic growth may stagnate.   

Will there be a trade war?  In our opinion, it seems unlikely.  Thus far, the Trump administration’s actions regarding almost any policy have been more measured relative to the Presidents rhetoric. This trend appears to be continuing with foreign trade.  Within days of the announcement of steel and aluminum tariffs the Trump administration said it may allow exceptions for close allies of the US, i.e. Canada, Mexico and the EU.  Also, the announced tariffs specifically aimed at China have yet to be implemented and a meeting between Chinese and American officials has been scheduled to discuss trade.  It is likely that these maneuvers are designed to create leverage for negotiating a better deal.  This tends to be the President’s negotiation style – create leverage by being unpredictable.  For decades the US has negotiated these deals with carrots.  In the President’s public view, that strategy has resulted in bad deals.  Now he’s getting out a stick. His goal – as it always is with this President – is to make a deal.  That is ultimately what we think will happen. 


Past performance is not a guarantee of future earnings.  Asset allocation does not assure a profit or protect against loss in a declining market.  Blake A. Stanley, CFP® is an Investment Advisor Representative of Legacy Advisory Group, LLC a Registered Investment Advisory Firm.

2017 Q4

2017 was a banner year for markets.  Rarely in history have the markets displayed such consistent increases.  We first noted the calm in the market in our 2017 Q1 commentary, and that theme continued through the year.   Looking specifically at the S&P 500 through 2017, we can see: 

At no point did the market close at less than 3% of its previously achieved high.   

December 31st marked the 13th consecutive month the S&P posted a gain (the last time this happened was in 1959).  

The highest daily increase in 2017 was 1.38%, one of the lowest on record.  

In prior commentaries, we have explored at length the various factors creating the calm in the market, and honestly, not a lot has changed.  Congress did pass a tax reform bill, but that was already being figured into market expectations.  So, we enter 2018 at the same pace and with the same calm that dominated markets in 2017. 

What will 2018 bring us?  In the past we’ve written about our trepidations with market forecasts and predictions (something about expert forecasting being as accurate as dart throwing chimpanzees).  It is uncertain what will transpire over the coming year and the useful benefits of prediction are limited.  What we do find useful, especially in times where the market calm tempts us to complacency, is to consider where we are.  Markets and economies go through cycles.  Markets move from a state of absolute fear (everyone is selling) to a state of absolute greed (everyone is buying) and then back to fear.   Economies go through cycles of expansion and recession and, while separate, these two cycles are closely related.  When the economy is growing, or shows the prospect of growth, markets tend to perform well.  When economic data points to a recession and a decrease in corporate profits, markets tend to perform poorly. 

Framing our thinking within the paradigm of these cycles is a reminder that things change.  It is especially critical to remember this right now as the length of the current economic expansion and the calm, steady upward climb of the market pushes us into complacency.  It helps us resist resting on our laurels because we remember that things will change.  Thinking in terms of cycles also helps us frame some of our portfolio decision making.  There are certain opportunities and risks commonly associated with the various parts of these cycles.  Having a general idea of where we are helps inform us of how our portfolios should be positioned and what we should be prepared for in the future.  So, let’s get out our road maps and see where we are at. 

Where are we? 

We are going to start with the easier of the two cycles: the economic cycle (oftentimes also called the business cycle).  The chart to the right outlining the business cycle is one that you can find in any Macroeconomics textbook (page 11 of mine).  It is important to remember that economics is not a hard science…economists are basically philosophers with calculators and spreadsheets.  That’s not an insult (or at least isn’t meant as one).  There are far too many variables, and so much of what happens in an economy is up to human behavior.  However, some general trends, like the business cycle, are consistent.  A well-functioning economy will expand, reach a peak, then enter a recession, before it eventually troughs and then goes into expansion.     

We’ve taken the liberty, in the style of a mall map, to indicate roughly where we are in the cycle.  Please don’t read too much into the sizes of peaks and troughs and don’t focus too closely on where the little star is, because I don’t know exactly where we are in the cycle and neither does anyone else.  However, certain characteristics tend to exist in certain parts of the business cycle.  Looking at the data across the board suggests our current business cycle is nearing a peak: unemployment, credit expansion, default rates, businesses growth, and other economic activities are at or nearing places typical of a business cycle that is getting close to a peak. 

This isn’t a call for a recession in 2018.  The recently passed tax reform bill will provide stimulus to the economy.  Companies are already announcing wage increases, special bonuses, increased capital expenditures, and job creation measures that will likely lengthen the cycle.  Even with that being the case, we may see some signs of a slowdown or even deterioration in economic data sometime in the next 12-18 months. 

Determining where we are in the market cycle is less data driven and more inference driven.  Market cycles do not tend to follow the same gradual changes of economic cycles.  Much of that has to do with what is driving market cycles: it is less about reality and more about peoples’ perception of reality.  Knowing exactly where we are is difficult but there are indicators you can look to: measurements of business and investor sentiment that can provide a loose picture of where we are at in the scale of Fear to Greed. 

To the right is a chart I keep and update on a continual basis (it didn’t upload very well into wordpress).  This is not something we came up with.  This is a guide investor Howard Marks uses and outlines in his book, The Most Important Thing. He calls it the “Poor Man’s Guide to Market Assessment” because it does not require a $25,000/year Bloomberg Terminal (has 2-6 computer screens and you can get about any economic/market data set imaginable) to complete.  We like it because of its simplicity and, because it’s generally true. 

Here’s how it works: the two right columns are opposing market characteristics.  You simply work your way down the list and bold which best describes today’s environment (I highlight but the spreadsheet didn’t transfer over well to wordpress). Is today’s economy vibrant or sluggish?  Is the outlook positive or negative?  Are lenders eager or reticent?   The more bold characteristics on the left, the farther in the market cycle we likely are.    

As you can see, most of the descriptors we chose when applying it to the US Stock Market are in the left column: lenders are eager, capital markets are loose, debt terms are easy, interest rates are low, spreads are narrow, markets are crowded, there are few sellers, recent performance has been strong, and asset prices are arguably high, to name a few.  These characteristics are indicative of late market cycles.  Admittedly, there is a lot of subjectivity involved in this chart.  It is not perfect, and neither are we in its application.  Another person may take the opposing viewpoint on some of our selections.  But when looking at market characteristics it appears we may be nearing the end of a market cycle. 

Knowing where we are doesn’t tell us exactly where we are going and when we will get there.  We don’t know what the year will bring.  Our guess is that there will be more volatility in the markets this year.  It is hard to imagine such a calm, steady year being followed up by yet another calm, steady year.  However, just because it is more volatile does not mean it will be worse or better.  But, predictions aside, the most important thing to take from all of this is not to buy into the calm.  It will not last.  The economy appears to be nearing a peak and domestic equity markets are exemplifying the characteristics of an over-priced, over-extended market.  We need to vigilantly work to hold assets that are reasonably priced, limit credit exposure, and be ready for mispricing opportunities that can arise if the market does turn.  We will continue to look for opportunities to invest capital at an acceptable level of risk.


Past performance is not a guarantee of future earnings.  Asset allocation does not assure a profit or protect against loss in a declining market.  Blake A. Stanley, CFP® is an Investment Advisor Representative of Legacy Advisory Group, LLC a Registered Investment Advisory Firm.

2017 Q3

Market Update

As the last quarter of 2017 begins, market sentiment continues to be overwhelmingly positive.  The calm in the markets we wrote about last quarter has proven to be resilient.  It seems nothing will scare off the unicorns grazing on the front lawn of the New York Stock Exchange. Geo-political tensions may rise (North Korea) and the Federal Reserve may tighten monetary policy (increasing interest rates and reducing the assets on their balance sheet), but the market continues its climb.  

The calm is not without some good reason.  A sober look at the details of these notable events reveals very little immediate risk to the economy or businesses. I by no means profess to be a geo-political expert, but conflict in Asia looks unlikely in the near term.  Kim Jong Un seems far too interested in staying in power to make the one decision (starting a war) that would with certainly result in him being removed.  Despite President Trump’s aggressive public stance, the US is unlikely to start another war in Asia unless it is absolutely necessary.  In addition, China has stated that it will not support North Korea if they fire first but will protect North Korea if the US or its allies takes the first action.  It looks like things will need will need more time to percolate before open war starts, if it starts at all. 

As to the monetary tightening, the members of the Federal Reserve Board (FRB) act as if they have taken the Hippocratic Oath: “First, do no harm.”  The board members have no interest in upsetting the current economic recovery.  From 2008 to 2013, the FRB took unprecedented steps to stabilize and stimulate the economy by providing banks and other financial institutions with liquidity through the purchase of treasury securities, mortgage backed loans and other debt instruments.  As the chart to right shows, the FRB increased the Federal Reserve Assets from $600 billion in 2008 to around $4.5 trillion in 2013. That’s an increase of 7.5 times.   This wholesale purchasing of assets allowed banks to bolster their balance sheets (most of the money went back to the Federal Reserve.  See chart on the following page…how convenient) and suppressed interest rates so companies – and households – could restructure their debt at  lower rates. 

Since 2014, the FRB has cautiously withdrawn this stimulus and has now started the process of unwinding it through interest rate increases and outlining a plan to reduce the assets on its balance sheet.  Removing this kind of stimulus from the economy is no small deal.  The FRB has been committed to cautiously making adjustments when they see that the strength of the economy warrants it. They telegraph every move far in advance to give financial markets time to digest their decisions and adjust.  Markets have acclimated and become comfortable with this process. 

There were also positive developments during this last quarter that appear to have further bolstered market sentiment.  Q2 GDP growth was recently revised up to 3.1% annual rate.  This is the first time a 3% growth rate has been achieved since 2015.  In addition, Congress and       the White House have re-centered their focus on tax reform.  While the details have yet to be worked out, the various proposals are favorable to economic growth, at least in the short term. Certain measures – such as the one-time preferred corporate tax rate on repatriated money and the reduction of the corporate tax rate – have the potential to push more cash into the economy, which could stimulate corporate profits and economic growth.

All-in-all, the external backdrop looks favorable for the market.  But risks are still plentiful.  North Korea is a reminder of the geo-political tensions that exist around the world, and although the near-term probability of conflict in that region seems low, things can quickly change.  The Federal Reserve Board can use caution and telegraph their every move, but they are again embarking on an unprecedented operation with unknown consequences.  And we have all seen how well Congress and the White House work together in passing a bill.  Tax reform is in the bag!  Right?  While the immediate backdrop looks calm, we remain mindful of where we’re at: as we have discussed at length in past writings, US markets continue to be at rich valuations, markets are complacent, stability tends to create instability – as the economist Hyman Minsky hypothesized – and we have experienced one of the longest and weakest economic expansions in US history.  All seems calm now but that could change fast. 

Investment Commentary – Return Free Risk

The struggle in a market like this is continuing to find assets that are priced well.  The Federal Reserve’s maneuvering has caused inconsistent price manipulations that have distorted markets and left investors with little option other than to price securities almost solely based on the decisions of the Federal Reserve.  This is clearly the case in bond markets.

In typical market conditions, a bond holder will receive more interest for bonds that mature at later dates. If you have ever purchased a CD at a bank, you have experienced this: a 1-year CD pays more interest than a 6-month CD; a 2-year CD pays more interest than a 1-year CD, etc.  Typically, it works the same in the US treasury market: a 5-year bond will pay a higher interest than a 2-year bond; a 10-year bond will pay more than a 5-year bond, etc.  When you plot these interest rates on a chart, you get what’s called a yield curve.

The chart to the below shows the yield curve as of two dates: The current October 2017 (blue line) and the beginning of year January 2017 (orange line).  What has happened over the last year is that the yield curve has “flattened”.   The interest rate on longer dated bonds – like the 30-year bond – have gone down (the end of the blue line is below the orange line), while the shorter dated bonds – like 1-year – have gone up (the beginning of the blue line is above the orange line).   This is not an abnormal phenomenon.  If fact, it is a normal occurrence in the credit cycle and is typically indicative of deteriorating economic conditions.  

However, other portions of the bond market are behaving in ways indicative of economic growth. Just as investors receive more interest for loaning their money out for longer periods of time, they also receive more interest for loaning money to less “credit-worthy” borrowers.  Companies with poor balance sheets and negative cash flow will have to pay more interest on their loan than Apple, who has $100 billion+ in the bank.  The difference in the rate these two borrowers pay is called the “spread” (I know…a lot of finance terms.  There’s a quiz at the end).  For example, if Apple is paying 2% and Sprint is paying 6%, then the “spread” is 4%.   

The chart below graphs the average spread for the last year of junk rated bonds over US Treasuries.  During this time, the spread has narrowed…the difference between what “safe” bonds are paying and what “risky” bonds are paying has decreased.  This is also not an abnormal occurrence but is indicative of improving economic conditions.  

Under “traditional” interpretations, these markets are giving us conflicting reports.  The Treasury Curve is telling us things are getting worse, and the High Yield Spread is telling us things are getting better.  Why?  I have my speculations on what the tea leaves are trying to tell me, but right now I’m more concerned with how they are making my water taste: with the curve flattening and spreads narrowing, investors are being paid less for increased risk.  That’s not very good tea.  

A good example of this is our recent experience in Senior Secured Floating Rate Bank Notes. In August of 2013, we committed a sizeable percentage (5-10%) of portfolio assets to these securities.  They offered good value relative to the rest of the bond market, the contracts were written with a lot of covenants (covenants are requirements lenders force upon borrowers to manage their risk), they offered interest rate protection, and default rates were low. This past quarter we unwound the positions. When we purchased these securities, we were earning over 5% interest.  That number is now around 3.75%. While that’s been good for us on a total return basis (when bond yields go down, prices go up), it is not much to be paid on loans given out to low credit quality companies.  In contrast, we could buy highly secure companies for 2.2% interest.  If default rates on the Bank Notes were to inch up to historical norms, then we would be receiving almost no additional compensation for the increased risk we were taking.  In addition, loans were being issued with fewer and fewer covenants, which further reduced our protection.  To steal a phrase from another portfolio manager, we were getting return free risk.  Given the changes, we sold the positions this last quarter.  The risk was no longer worth the reward.  We will continue to look for opportunities to invest capital at an acceptable level of risk.


Past performance is not a guarantee of future earnings.  Asset allocation does not assure a profit or protect against loss in a declining market.  Blake A. Stanley, CFP® is an Investment Advisor Representative of Legacy Advisory Group, LLC a Registered Investment Advisory Firm.

2017 Q2

Market Update – The Great Complacency

If no news is good news, then all I have is great news for you today. The first half of this year has seen stock markets across the globe make steady upward climbs.  The indexes in the chart below represent major markets across the world.  As you can see, almost all major markets are in positive territory for the first half of the year.

The markets seem as calm as Hindu cows.  These increases have, for the most part, come steadily without a lot of fanfare or turbulence.  Investors believe this calm will continue at least in the short term.  The VIX, represented in the lower-right chart, is an index developed and maintained by the Chicago Board Options Exchange (CBOE).  Commonly called the “fear gauge,” the VIX is the measurement of the expected volatility (how much the index will change in value) of the S&P 500 over the next 30 days.  As this chart illustrates, the VIX is at the lowest level on record since its development in 1994.  The S&P 500 is not alone in its low realized and expected volatility measures.  European and Asian markets are also at or near historical lows.    

In several markets around the globe, we would argue these market increases are warranted.  We have long held the opinion that Asian and European markets are under-valued, especially from a relative standpoint.  While the US market has continued to increase the last few years, these markets have stagnated until recently. Europe seems to be entering the stage in the economic cycle that the US began in 2009…slow yet steady growth.  Beyond foreign developed markets, emerging markets appear to have come out on the other side of another round of currency pressure in good health. This illustrates an economic resilience that hasn’t been there in the past. 

In contrast, the US economic expansion and bull stock market are getting a little long in the tooth.  The current economic expansion has lasted 96 months, the third longest expansion since 1854.  At almost 100 months long, the current US bull stock market is the second longest on record.  Neither of those facts spells near term doom, but there are other signs of frothy investment markets.  Just to cherry-pick a few:

Traditional valuation metrics are historically high – Total Market Cap to GDP ratio is around 120%, a number surpassed only at the height of the Internet Bubble in 1999/2000.  Shiller CAPE index has now surpassed the level it reached in 2007, just prior to the Great Recession.  In fact, there have been only two other times in history when it has been this high or higher – 1929 and 1999/2000.  When talking about stock markets, those are not good years to be associated with. 

Stock valuation metrics are being ignored – To site a specific stock overvaluation, during the last quarter Tesla, an electric car manufacturer, surpassed Ford in market value.  Tesla has a fraction of the revenue of Ford ($8 billion vs. $151 billion), a fraction of the assets ($22 billion vs $237 billion) and has never posted an annual profit.  This sounds familiar to the internet bubble, when everyone was banking on future revenue that was just supposed to come from somewhere. 

High Margin Debt Level – The New York Stock Exchange publishes monthly margin debt levels (borrowed money to buy stocks[i]).  It is currently the highest on record. When viewed as a relative measure to US Gross Domestic Product (GDP), it is at the same level as it was in 1999 and 2007. 

Low Institutional Investor Cash Holdings – Institutional investors are almost fully invested, with 2.25% of their account holdings in cash. This is the lowest level since 2008.[ii]

Argentina’s Bond Offering – To be fair, this is example isn’t from the US market, but it shows how desperate people are for higher yielding bonds. Just a few weeks ago, Argentina successfully issued $2.75 billion in US denominated bonds that mature in…wait for it….100 years!!!.  This bond issue was oversubscribed…there were 3x more buyers than there were bonds to sell.  This is Argentina, a country that has defaulted or rescheduled payments on external debts 5 times since 1950 (1951, 1956, 1982, 1989, 2001)[iii].  Their most recent external default holds the record for the largest sovereign external default at $95 billion and, for some reason, people think it’s a good idea to lend them money they don’t have to pay back for 100 years.  It befuddles me. 

These factors – steady increases in market value, low volatility, and a general disregard for risk and valuation – are indicative of a complacent market.  Complacency tends to create instability in furthering misallocations of capital. In other words, people feel safe so they ignore risk.  When you add to those factors a very long bull market by historical standards and investors who are fully invested and even leveraged (margin debt) then you have a scenario where things will likely change quickly when they change. 

The timing of the change is impossible to know. Equity markets could continue to go up.  The last time the Shiller CAPE ratio was this high, the market continued to go up for another 2 years.  Economic data continues to be generally positive and corporate earnings are still improving.  These factors could continue to support an overvalued market.  However, with the above risk factors we will maintain our conservative approach to US market exposure. 

Investment Theme – Water

For a midwestern boy, the concept of “water shortage” is completely foreign.  I grew up not far from the Missouri River.  Most of my Saturdays from the time I was 13 until I turned 20 were spent fishing on the large lakes of central Missouri – Truman, Stockton and Pomme de Terre.  As an adult, I’ve spent countless hours fly-fishing in streams.  One of these, Bennett Springs, has a daily flow of over 100,000,000 gallons that, as the name suggests, comes out of a hole in the ground. I’ve spent several weeks fishing in Canada, where you can’t seem to drive 3 minutes without passing a lake.  For the last few years, my family and I have vacationed several times at Lake Michigan.  In my world, water is everywhere and in abundance.

I – and all of you, except our west-of-the-Rockies clients – live in one of the richest water locations in the world.  The Mississippi River Valley stretches from the Appalachians to the Rocky Mountains.  Hundreds of rivers and streams contribute to the system as it meanders its way from as far north as Montana and Minnesota to the Gulf of Mexico. The Amazon and the Congo Rivers are the only river systems in the world with larger drainage basins.

Reality is much murkier in other places in the world, even some places in the US.  The graph to the right illustrates that much of the world is going to be under stress to provide enough water to support their populations[iv].  Global population growth over the last century has placed a lot of stress on water systems.  In most developed parts of the world, water infrastructure has been able to keep up with growth.  For example, during the 20th century, 45,000 dams were built around the world, which increased the world reservoir capacity by 4x, and aquifers were discovered and tapped to supply water to otherwise water poor regions[v].  But the efficiency of those measures is starting to hit their limit.  The number of dams that can be effectively put on a river is limited, and aquifers replenish at a very slow rate. 

In addition, current water infrastructure is aging and will need extensive replacement and repairs in the next 10 to 20 years.  The American Water Works Association (AWA) claims the US is hitting the “Replacement Era” of water systems.  The type of piping used in water infrastructure has changed over the last century, but oddly enough, newer pipes have less longevity than older ones.  In an almost perfect storm, 3 different types of piping will be hitting the end of their “life expectancy” within the next decade.  This same scenario is being played out in other areas across the globe.  For example, Mexico City loses 40% of the city’s potable water through leakage of old pipes every day[vi]

Developing economies face even greater challenges.  Having frantically thrown together water systems to meet the increased demand from industrialization and urbanization, many developing or recently developed countries are facing pollution problems.  It is estimated that half the surface water in China and India is contaminated to an unusable point.  In 2016 a report from the Chinese government, it was stated that 80% of underground well water was unfit for drinking or bathing[vii]

All of these varying issues will need to be solved, and solving them will cost money.  As global populations continue to increase, new systems and technologies will be required to meet demand.  Since water cannot be created, this will have to be done through increased efficiencies in use/reuse and delivery (desalinating ocean water is another potential). As to the aging infrastructure, the AWA estimates that the cost for replacing drinking water systems will be $13,500 per household (sorry…. your water bill is going up)[viii].  To stem the pollution of their waters, developing countries will need to increase regulations on industries on the water they release into the system, which will cost money to implement.

We like the investment opportunity this presents.  Besides oxygen, water is the most basic necessity in life.  People need access to it, and they want it to be clean.  Recent experiences in Flint, Michigan have demonstrated just how important it is to get right.  A lot of money is going to be spent on water over the next 10 to 20 years.  We currently have a small position committed to this area and will be likely be increasing it over the coming months. 

We will continue to look for opportunities to invest capital at an acceptable level of risk.


Past performance is not a guarantee of future earnings.  Asset allocation does not assure a profit or protect against loss in a declining market.  Blake A. Stanley, CFP® is an Investment Advisor Representative of Legacy Advisory Group, LLC a Registered Investment Advisory Firm.


[i] Data can be viewed here: http://www.nyxdata.com/nysedata/asp/factbook/viewer_edition.asp?mode=tables&key=50&category=8

[ii] http://www.businessinsider.com/stock-traders-look-dangerously-overconfident-cash-holdings-2017-7

[iii] This Time is Different: Eight Centuries of Financial Folly by Carmen M. Reinhart & Kenneth S. Rogoff

[iv] Chart from World Resource Institute http://www.wri.org/resources/charts-graphs/water-stress-country

[v] Water: The Epic Struggle for Wealth, Power, and Civilization by Stephen Solomon

[vi] ibid

[vii] https://www.nytimes.com/2016/04/12/world/asia/china-underground-water-pollution.html?mcubz=0

[viii] Water 4.0: The Past, Present & Future of the World’s Most Vital Resource by David Sedlock