2020 Q4

Fair warning…this is a long one. 2020 was quite the year, and there’s a lot to talk about. If it makes you feel any better, I left out more than I put in (I don’t even touch the election…you’re welcome).

We hope everyone is doing well and adjusting in this ever-changing environment. To say there was a lot of change in 2020 would be the understatement of all understatements. This was a challenging year for everyone, for some more than others, but we all experienced some level of challenge or, at the least, inconvenience.

I’m not one to put much stock into the New Year. Very rarely do things in life tie up as neatly as they do in movies or books, and the sense of finality we get from seeing the closing scene of a movie or the turning of the next chapter of the book rarely happens in life, especially once you pass the educational milestones of our youth. For me, the New Year doesn’t really represent any closure…life will be much the same as the calendar rolls from December 31st to January 1st. I admit, I am probably in the minority in this way thinking, especially this year. As December rolled around, the excitement surrounding the close of 2020 and looking hopefully towards 2021 was palpable. As the COVID vaccine circulates, people are looking forward with great anticipation for the return of some level of normalcy. This social zeitgeist is important as we look ahead economically. If and as normality materializes, people will likely let loose: travel, eating out, spending time with friends, going to the movies, all of those activities we all had to abstain from in 2020. As the year presses on, and the pandemic hopefully abates, activity will pick up, and we are likely to see some big economic numbers. 

Any economic gains in the next year will occur with the backdrop of massive economic damage. Service sector jobs lost in the shutdowns won’t all be coming back in the next year. Corporations that had spent the last 10 years bingeing on debt just had to double down and borrow more to make it through a pandemic. For many companies, the increased debt will strain their cash flows going forward and remove growth capacity. Business closures and permanent work from home arrangements are changing the commercial real estate market. Though we expect things to improve, we also don’t know what will happen with COVID. New mutations of the virus appear to spread faster, and the vaccine rollout is proceeding at a much slower pace than the country had hoped. This reality may require more severe lockdowns before herd-immunity is achieved. This has already happened in the UK, and they are looking at another loss in GDP. Financial markets and the economy will have to move forward on shaky and uncertain ground.

If you read the annual predictions of what the “pros” think is coming for markets in 2020, you will find people in opposite corners. In one corner, we have the doomsday predictions: the market got too far ahead of itself in 2020, is not recognizing the massive damage done to the economy, and is bound to come back to reality in a scene reminiscent of the 1999 tech bubble pop. In the other corner, market euphoria: we are about to reach the other side of the pandemic, the world is about to party like it’s 1920, and trillions more in stimulus will be passed this year, which will drive economic activity and the stock market to all-time highs. The reality is, it’s anyone’s guess what the market will do this year. As we’ve said many times before, where the market moves from one year to the next isn’t about math or predicting events, it’s the response of the unpredictable masses to the unknowable future.[i]

Consider 2020. What if I told you in November 2019 that in 2020, governments around the world would shut down their economies for months in response to a pandemic, and the US stock market would still post double digit gains? You might have sent me to see Nurse Ratched. I would have probably gone voluntarily. That’s what happened though. True, you didn’t have all the information. I didn’t tell you that central banks and governments responded with never-before-seen levels of stimulus. Nor did I mention the concentration of market gains in tech stocks benefiting from demand shifts caused by stay-at-home orders. But you never have all the information, and it’s anyone’s guess how the masses will respond. History can be a guide, but as I read the various opinions floating around, I’m reminded of what Will and Ariel Durant, authors of the 10-volume The Story of Civilization, said: “History is so indifferently rich that a case for any conclusion from it can be made by a reflection of instances.”[ii]Is it 1999 or 1920? Is it the end of a stock market party or the beginning of one? I can make a case for either. I could also make a case for neither.

With uncertainty ahead, we continue to be disciplined in our selection of investments. In global markets, we see pockets of euphoria and pockets of reasonable value. To an extent, we have tried to position the portfolio with investments of reasonable value. Emerging Markets, Asia, renewable energy (particularly solar), and biotech are all positions we held at the beginning of the pandemic and will likely continue to hold for the foreseeable future. Going into the pandemic, we believed they represented good long-term value. We held to that belief, and they performed very well over the course of the year. During the year, we also made a lot of changes. We usually don’t go into specifics in our commentary, choosing rather to discuss this in client meetings, but given the events over the last year, we think it’s fitting to provide some additional information. Here are some of the adjustments we made to portfolios over the last year:

  • Allocation to precious metals was increased, adding silver to the portfolio back in April. We plan to maintain this higher allocation as debt loads balloon, risks remain elevated, and direct economic stimulus adds to money supply.
  • There were a couple corporate positions added that we had been watching for a long time.  Market turmoil priced these very attractively, and we were able to purchase them with a good yield. A few of these companies should benefit very well if there is more turmoil in the corporate bond market, as we expect there will be. 
  • We shifted some assets from a very conservative income fund (FPA New Income) to a more opportunistic multisector bond fund (Guggenheim Total Return). We saw the pandemic as a catalyst to an increase in corporate defaults resulting in volatility in the debt market. We wanted a fund that would be opportunistic in the chaos. Defaults did go up, the fund was able take advantage of some volatility, but the Federal Reserve actions stabilized corporate bond markets, at least for now.
  • In early November, we added a small cap fund (invests in smaller companies). As we highlighted in the Q3, small caps have seen three years of flat performance while large caps have had stellar performance. The performance disparity increased in the first part of 2020 as the market – rightfully so, in our opinion – saw an increased risk in small companies. By the third quarter, these companies had been largely left behind in the market rally and looked to be priced at good long-term value, on a selective basis (there’s a lot of bad out there too).
  • We added a precious metal miners fund (technically, we implemented this the first week of 2021). With suppressed precious metals prices over the last several years, these companies have had to tighten their belts, increase their operational efficiency, and reduce their debt in order to be profitable. Generally speaking, they are now sitting on clean balance sheets and high operating margins. If metal prices stay at their current levels, future earnings will be good and will only get better if precious metals prices go up, which we suspect they will. 
  • As prices went down, we added to several of our existing positions. This is especially true in the energy sector. Prior to pandemic, we believed the energy sector was very cheaply priced. The pandemic made them even more so, and we added to several positions as prices went down.
  • There were a few positions we did not want to carry through the pandemic that we eliminated.  A few were sold early in the year at losses. One in particular, a pipeline fund, had extensive losses. That one hurt. But we were able to reallocate the capital from those investments and put it to work in other places that we’ve mentioned above.

Our long-term clients will likely recognize this as many more changes relative to activity in the past. It is true, we don’t have a lot of turnover in our portfolios. We tend to buy positions that we believe are well priced and have potential ahead of them, and we often hold those positions for several years. But market chaos tends to create opportunities.  In the chaos of the last year, we were able to add—or add to—several quality investments at very reasonable prices. They should serve the portfolio well in the long-term.

What is going to happen with all this debt?

This commentary has already reached its normal length. If you’ve had enough, this is a good place to stop. This next section is a bit of bonus dealing with a subject that we think will have huge long-term implications but doesn’t have much immediate impact on our investment thinking (though it does have some). We also hope it will provide a little understanding as to why many in the Federal Government believe they can continue creating money out of thin air without considering the cost to the future.

In response to the pandemic, the Federal Government passed two stimulus packages. These measures blunted the losses in the economy, given our elected leaders’ decisions – right or wrong – to shut down large swaths of the economy.  But at what cost? The US Federal Debt at the start of 2020 was $23.2 trillion. It ended the year at over $27 trillion. That’s almost a 20% increase in one year. This trend is unlikely to change. President Biden said the recent stimulus package passed in December was just a “down payment.” With Democratic control of Congress, some expect to see $2 trillion more in stimulus packages. Federal Tax revenue per year is “only” $3.4 trillion. Almost half of that is payroll tax, which goes straight to Social Security and Medicare programs. There is no room for any stimulus in the budget. Any additional stimulus dollars will go straight to the Federal Government’s debt.

This has left many wondering, how does all this debt get paid for? Many politicians and a few economists are now concluding that it doesn’t need be paid for, arguing that the amount of Federal Debt doesn’t matter. Enter Modern Monetary Theory (MMT), an economic theory that is starting to influence more policy decisions and will have very real impacts on our lives and your investment portfolios.  

The basic premise of MMT is that a currency issuer (like the U.S., which issues dollars and whose debts are all in dollars) cannot run out of money. Since all our debt is in dollars, which the US Government creates, it cannot possibly default on its debt. If a debt comes due, the government can pay it by simply creating more money. Under this premise, the fact that we have a $27 trillion debt load means virtually nothing and taking on more debt has no impact on the government’s ability to further spend. Want to introduce a social program, like a jobs guarantee, or cover all healthcare cost or provide free college to all? You first need to find money in the budget to cover it, right? Nope…in MMT, the budget does not matter. You can spend without consideration of whether the government can afford and what it does to the Federal Government Balance Sheet.

This can be difficult to wrap your mind around at first, because we are so used to looking at finances through the lens of our personal budgeting. You have income and if you spend more than you make, you must borrow to pay for the shortfall. If the borrowings get too high, you can’t pay your debt, and you go broke. We tend to look at the Federal Government the same way. They have income in the form of taxes. If they spend more than they bring in then they have to take on debt to cover the shortfall and if the government debt gets too high, they go broke.  MMT would tell you that’s not an apples-to-apples comparison, because you are a currency user, whereas the Federal Government is a currency issuer. You can’t create money to cover your shortfall. The Federal Government can.

The next natural question to ask is, if debt doesn’t matter, why doesn’t the government print as much money as it wants? To be clear, MMT does not propose that the Federal Government can print money with no limit. It’s not a governmental blank check. It shifts the limiting factor from debt to inflation. Inflation is the constant increase in prices of the goods and services in the economy over time. We are familiar with this concept. It’s why a burger costs more today than it did 20 years ago. Most economists argue that a little inflation is good, but there is a point where there is too much inflation.  There are a lot of historical examples of inflation going off the rails. The classic example is Weimar Republic in 1923, where the cost of a loaf of bread went 250 marks in January to 200,000 million marks in November. That’s not good. People were literally taking wheelbarrows full of cash to the market to buy a loaf of bread. This inflation was, in part, a result of too much money being printed. So, in the world of MMT, keeping inflation at a reasonable and manageable level is the limiting factor to how much money the government prints.

MMT was a fringe theory just 10 years ago. We remember looking into it then as we saw it as a natural outcome to the massive money printing that happened in the wake of the financial crisis. Over the last 10 years, we have seen it rise to more prominence. Progressive liberals have adopted it as a means to fund many of the social programs they would like to see implemented. We expected it be a prominent component of the 2020 election. COVID-19 moved the focus elsewhere, and it never became a primary topic. But, it was functionally implemented when the government provided unprecedented monetary support to the economy with barely a nod by either party to what it would do to the debt level of the US Government. There was more pushback on the second stimulus. After it passed the Senate, Senator Rand Paul gave a speech about how its passing represented the adoption of MMT. We believe he’s right. With more stimulus measures coming in the future and a Democrat-controlled government that would like to see trillions spent in infrastructure, renewable energy development, health care, and many other social programs, MMT will be the counterargument to many congressional leaders’ opposition based on incurred debt.

Should this be concerning? Maybe. There is much about MMT that makes sense. For one, the US Government can’t run out of money. The government can’t default on debt that’s repaid on money the government creates. In that sense, debt isn’t a limiting factor. So, what is the concern?

We see a couple problems with MMT. First, it assumes economists have some predictive accuracy on inflation. Before a new program is implemented, the idea is to evaluate whether that would cross the tipping point of creating too much inflation. Sounds nice but the last 10 years have been rather condemning on the idea that economists understand inflation. Relying on our limited understanding of inflation, and what causes it, to red-light/greenlight projects seems a little foolhardy.

The second, and more worrisome, problem we see with MMT is once you cross into unwanted inflation, how do you get back? Dr. Stephanie Kelton is the one of the leading proponents of the theory. Interestingly, Dr. Kelton once worked at the University of Missouri Kansas City (UMKC) and the founder of our firm, Jack Kynion II, called her up one day to hear about this out-there philosophy. From those humble beginnings, she’s risen to be a thought leader on MMT. She recently released a book called The Deficit Myth, where she discusses the basic premises of MMT and outlines many challenges in the US that could be addressed by shifting our thinking to MMT. Dr. Kelton’s suggestion in the book is that government could use their money creation powers to provide for a host of social and infrastructure programs, like jobs guarantee, fully fund healthcare, renewable energy infrastructure, infrastructure at large, and college education, among others. Once inflation starts to pick up, you throttle back. That’s where we fear it breaks down. Let’s say we start going down this road of funding all these programs and somewhere along the way inflation starts to go nuts. What’s next?  MMT proponents suggest that congress would act to adjust taxes and government spending. Here is Dr. Kelton as she suggests adjustments to current monetary and fiscal policy:

Or maybe congress could help fine-tune the economy with better real-time adjustments to government spending and taxation?[iii]

You want Congress to do what?!? Fine-tune? Real-time? Those terms don’t compute with Congress. All these decisions will be politicized. If the inflation threshold is crossed, which social programs do you take away? Which congressional representatives will sign up for hosing their constituents? Increase taxes? To who, how much, and how? These are questions that don’t get answered quickly, and they’ll be answered largely in the self-interest of our representatives. If we are counting on them to make quick decisions to reel in inflation, we will likely be left with a lot of inflation.

Regardless of our beliefs toward MMT, we believe we will see a greater shift to this mode of thinking. In the next few months, there will likely be $1.9 trillion in stimulus. Then, there could be additional funding proposed for other social programs. The support in Congress for the programs will likely be there, but as dissent is raised, the rallying call will be MMT. In fact, Dr. Kelton – who once worked for Senator Bernie Sanders, who will be chairing the Senate Budget Committee—has been placed on President Biden’s economic team. We will likely hear more and more often that the deficit doesn’t matter. We will be watching this closely as it will directly impact our day-to-day financial lives and investment portfolios. We will continue to look for opportunities to invest capital at an acceptable level of risk.


Text Box: 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 Limited Co. a Registered Investment Advisory Firm.

[i] For more pontifications on the limited usefulness of investment professional prognostications, see our 2016 Q4 commentary. Don’t have one? Request a copy here: bstanley@finadvs.com

[ii] Lessons from History by Will & Ariel Durant, Page 97.

[iii] The Deficit Myth: Modern Monetary Theory and the Birth of the People’s Economy by Stephanie Kelton, page 55.

2020 Q2

After a tumultuous first quarter in the markets, government and monetary intervention along with the hope of a V-shaped recovery have fueled a market rebound that is nothing short of remarkable.  The S&P 500 lost 34% from its peak on February 19th to its low point on March 23rd.  As of this writing at the end of June, the market price is right around where it was on January 1st. That seems almost unbelievable given that we sit at double-digit unemployment and are staring down the largest calendar year economic contraction since the budget cuts following WWII.

Despite the exuberance, the market optimism still sits on fragile ground. In mid-June the Federal Reserve remarked that they did not expect a full economic recovery till the end of 2021. That news, along with renewed fears of a second wave of the virus, sent the market down by 5% in a day. The market immediately rebounded over the next few days as the Federal Reserve announced the initiation of their corporate bond buying program. We expect that this kind of news/response will continue as the markets balance the realized and persistent economic damage the virus is causing against the highly accommodating policies from the Federal Government and Federal Reserve Bank. 

In our last commentary, we outlined several unknown questions related to the virus and the economic damage it has caused. Most of those questions continue to be unanswered. The public commentary surrounding the economic recovery has pretty much abandoned the concept of a V-shaped recovery but appears to be optimistically looking ahead to a steady uninterrupted economic recovery. A lot must go right for that to happen. For instance, there cannot be a second wave of COVID-19 that causes the economy to shut down. We are going to “stay in our lane” as the saying goes by not venturing an opinion here, but if history is any indication, the probability of a second wave is high. There were three influenza pandemics in the 20th Century: the 1918 Spanish Flu, the 1957 Asian Flu, and the 1968 Hong Kong Flu. Each of them had a second wave. There are already resurgent pockets of cases in certain areas of the globe. Beijing has re-instated lock-down procedures due to a new outbreak in cases and here in the US several states that re-opened early have seen upticks in the number of reported cases. Second wave or not, COVID is likely to be with us for some time, and will continue to negatively impact the economy.  

In addition, we still do not know how damaging it was to close the economy for two months. Across the economy, short-term concessions are being made: landlords are deferring rents; corporate lenders are relaxing covenants so corporations don’t enter into technical default; PPP loans to small and mid-size businesses kept employees on payroll; and increased unemployment benefits supported people who were “temporarily” laid-off. Those are all temporary measures. Eventually, landlords and lenders will expect payment to be made, companies will begin to assess how many employees they really need to retain, and the government will not likely continue to pay people more to stay at home than they were earning in their jobs. As these short-term concessions end, the ripple effects may threaten a steady economic recovery.

Corporate Debt

What is becoming apparent is the impact all of this is having on Corporate America’s balance sheet. While corporate cash flow is more complex than our personal finances, they are the same at the most basic level. Like you, companies have bills to pay…rent, loans, interest, etc. In order to pay those bills, they need access to cash. That cash can come from one of three places: income, savings, or borrowings. The economic shutdown reduced income substantially for many – probably most – companies. For those companies who no longer had the income and did not have enough savings to pay their bills, their only remaining option was to borrow funds. That’s exactly what corporations did in historic amounts in the 1st and 2nd quarter. At one point, corporate debt, as a percentage of US Gross Domestic Product, jumped 10% in a week.

A lot of this money is being borrowed by companies who were not in good shape going into the crisis. The loss of income and increase in debt are threatening technical default for many borrowers. Lenders are currently sympathetic. Many have allowed corporations to report last year’s earnings in order to delay or avoid default. Some companies have even adopted a new earnings acronym. Many of you might be familiar with the term EBITDA. It stands for “earnings before interest, taxes, depreciation, and amortization.” It’s supposed to provide investors/debt-holders with a realistic view of how much money a business is making. It’s not a concept we particularly care for, but I digress. Now, some companies have adopted a new metric, EBITDAC…earnings before interest, taxes, depreciation, amortization and – wait for it – coronavirus. Yes, they’re providing a number of what they would maybe-might-have-earned had COVID-19 never happened. If only we could all live in such a fictional world.[i] 

All this is occurring with the Federal Reserve providing a significant backstop for corporations. When corporate debt markets buckled in March, the Federal Reserve promised the purchase of investment grade and “recently investment grade” corporate debt. This had the immediate effect of attracting money back to corporate debt markets. This lowered interest rates and gave corporations access to money. These corporations would have otherwise been left out in the cold. While those measures provide companies with the ability to pay their current bills, the additional debt will make it more difficult to pay their future bills or invest in the growth of their business. There were already a large number of what has affectionately been termed “Zombie Corporations,” companies who have more debt service costs than profits. With the amount of debt being taken on by corporations, this number will only increase.

Financial Engineering

It doesn’t seem possible for corporations that can’t pay their bills to continue borrowing money forever. It flies in the face of good, common sense in fact. Actions taken by the Federal Reserve, however, have served to distort free capital markets.

Their intentions seem to be good. If corporations go bankrupt, people lose jobs. When people lose jobs, they stop spending money. When people stop spending, corporations make less, and then have to lay off more people. The cycle continues, and in healthy and mature economies, it finds equilibrium. Eventually hiring will resume, people will have more money to spend, corporations earn more and hire more people. The Federal Reserve partially fills the role of smoothing those cycles but in the last two crises (Financial Crisis of 2008 and COVID-19), the Federal Reserve has stepped in with ever greater measures of support for financial markets than it had before. Actions thought unimaginable before 2008 are now commonplace. We may look back in another 5 years saying the same thing about 2020.  The result, though, is a system increasingly reliant on outside support.

Federal Reserve actions not only does create a reliant system, but also distorts what should be the natural capital flow in free markets. In a free capital market, well run and profitable – or potentially profitable – companies will attract investments, while poorly run, unprofitable companies will lose the capital support of investors. This motivates corporate operators to run their companies prudently without taking undue risk. It also ensures that companies that should not remain in business due to mismanagement or changing market forces don’t survive. With the support of the Federal Reserve, it appears corporations who shouldn’t continue to attract capital are not having a problem finding capital.

One particular example we saw in the first quarter was Cinemark. As a movie theater operator, the last several months have been particularly hard. Most, if not all, of their revenue was gone due to shutdowns. They needed cash, and when the corporate bond market buckled in March, it didn’t look like they were going to be able to borrow it. Then the Federal Reserve announced its intention to buy corporate bonds. Immediately, capital flowed back into markets, interest rates came down and the liquidity was available for Cinemark to issue a new round of bonds. That’s a win, right? Maybe, but will the current movie theater model survive in a post-COVID world? I hope so. I love going to the theaters, but I wouldn’t want to bet on it right now. Until the Federal Reserve stepped in, it didn’t look like there we many people who were willing take that bet either. That’s happening over and over again in the markets: companies are getting capital that maybe shouldn’t be.

Even with the Federal Reserve’s efforts to keep capital flowing in corporate debt markets, we have still found some good yield within the public and private debt markets. This is a sector we have avoided the last couple of years in anticipation of a turn of the credit cycle. Interest rates had been too low to justify the risk. That changed in the first quarter. With an asset manager who has particular talent in managing credit risk, an attractive yield can now be obtained at an acceptable level of risk. We have taken this opportunity to increase our exposure to debt markets. If equity markets become volatile again, these assets should continue to pay good yield. Plus, the capital is protected so long as the manager has been adequately selective about their lending or purchases. We believe the managers we have chosen have and will continue to exercise the proper prudence. As always, even in this environment, we will continue to look for opportunities to investment capital at acceptable levels of risk.  


[i] https://www.ft.com/content/85d6f19c-0eea-4f70-a906-40b03d862f03).

2020 Q1

First of all, our prayers are that you and your families are staying safe. We are living through a strange and unprecedented time. Just a few of months ago, we were looking at calm markets with a slowing but growing economy. That quickly changed as COVID-19 hit the US, and the economy basically shut-down. The impact on financial markets was severe. Never have US financial markets displayed the kind of volatility in such a short period of time. In a matter of weeks, the market dropped almost 40% and then quickly recovered much of the ground it had lost. Along the way, we witnessed asset price fluctuations like we have never seen before, including during the 2008 Financial Crisis. 

With financial markets struggling, the Federal Reserve stepped in with a massive volume of purchases, expanding its balance sheet by $2 trillion in less than a month.  It took years for that to happen after the Financial Crisis in 2008. To provide the economy and individuals some support, the Federal Government also stepped in to provide stimulus checks for individuals and payroll support loans for businesses.  Never has there been a greater effort from the Federal Reserve and the Federal Government to prop up an economy.  

All of this makes the future more uncertain than usual.  The modern world has never experienced a period where the global economy shut down for months, and no one alive today has faced a pandemic of this magnitude.  This leaves a lot of questions about how events will play out:  How long will it take for the economy to “re-open?”  Will there be a resurgence or a second wave of COVID-19?  How soon will a vaccine or treatment be available?  How much damage has been done to the economy?  How willing will people be to return to normal social activities?  And longer-term, what effect will all this new debt have on economic growth going forward?  These questions are being weighed and considered in the press and by governments around the world but knowing the answers just isn’t possible.  The innumerable predictions, the media commentary, and government talking points are all just speculation.  Valuable speculation (that’s a rare thing) but still speculation.  Even in uncertainty, there are a few things we can have a high degree of confidence in, which have informed and will continue to inform our decisions about how to handle portfolio allocations going forward.   

First, the US economy and the global economy will recover but it will take some time.  Financial markets seem to be pricing in a “V-shaped” economic recovery: the economy crashed quickly, and it will jump right back up.  We see that as optimistic.  It may be a V-shaped recovery, but it’s going to look like a V my five-year-old wrote, meaning that the right side of the V is going to look very different than left side.  Parts of the economy are at an absolute standstill and re-starting does not happen with the flip of a switch. A strong initial jump is possible, even likely, but it will take time for people to fully return to their normal activities. The 30+ million recently unemployed will not all find their jobs waiting for them. It took 3 years for GDP to recover after the 2008 Financial Crisis.  We would not be surprised if this recovery were to take that long, or longer.  

Second, and related to the first point, a lot of bad economic data and corporate earnings reports will come out over the next few months.  Again, estimates on how bad are all over the board.  We have seen estimates ranging from a 10% total reduction in GDP to a 40% total reduction in GDP. Corporate earnings will not look any better. Over the next few months, we will begin to understand the toll levied against the economy. As we have said many times before, we cannot predict what the market is going to do over the next few months, but as of right now, financial markets appear to be overly optimistic.  We believe there is more pain to come in the markets as the damage assessment becomes clearer.  

Third, this situation will result in winners and losers among countries and companies.  Countries with the capacity to spend financial reserves, take on more debt and expand their monetary base without immediate adverse consequences will probably come out of this ok.  In contrast, over-indebted countries with insufficient financial reserves will have a much more difficult time.  Similarly, companies with strong balance sheets and a capacity to spend during this crisis to increase market share will ultimately come out of this stronger.  In contrast, smaller companies or over-leveraged companies will struggle to access cash or, in the event Federal Reserve keeps bond markets liquid, will come out of this with more debt and less cash flow.  

Fourth, corporate debt markets will be volatile.  Market reactions in March shined a big spotlight on the corporate debt market asset bubble that we noted back in our 2018 Q4 commentary. Certain areas of the bond market dropped precipitously in price. Actions taken by the Federal Reserve brought some calm to those markets, but the problems are not going away.  Coming into 2020, corporate defaults were on the rise and Rating Agencies were warning of a coming wave of rating downgrades.  Now that the global economy has shut down for two months, we should expect even more corporate defaults and ratings downgrades.  

Lastly, the Federal Reserve and the Federal Government will continue to pull out all stops to support the economy.  As we noted above, the concerted efforts by these two institutions to provide liquidity in the markets and stimulus to the economy has been unprecedented.  This will continue, although the pace of help from the Federal Government will likely slow as the process to pass stimulus packages becomes increasingly politicized.  

With those factors in mind, we will continue to hold our high-quality positions and look to be opportunistic about buying high quality growth assets at reasonable prices.  We have already executed on a few opportunities and if market volatility persists, more of those opportunities should come around.  It’s important to note here that we are looking for good long-term opportunities.  New positions may experience immediate priced declines, but if done correctly, these opportunities will pay handsomely in the long run.  We have also made some adjustments in the portfolios to take advantage of the dislocations that are likely to occur in the corporate bond market. 

Hovering over these decisions are the actions taken by the Federal Reserve which will continue to have implications across financial markets.  For comparison, in the wake of 2008 Financial Crisis, as the Federal Reserve pumped liquidity into the financial system, markets shrugged off poor economic data and began to climb.  We are mindful this could happen again.  Given the uncertainty, we need to carefully manage risk while maintaining exposure to potential market growth.   The weeks ahead are likely to be challenging, regardless of what the market does.  Each one of us is having to live through this situation in our own way.  For some of us, this virus presents very little risk to life or livelihood.  For others, the risk is high.  Many of us probably haven’t left the house for 5 or more weeks, except to get groceries. That’s hard for some of us but enjoyable for others.  Some of us work in healthcare or have an essential job that requires going to work and risking exposure.  We want to thank you for risking yourself and your loves one on others’ behalf.  Whatever your situation, our prayers are with you. We will continue to look for opportunities to investment capital at acceptable levels of risk.  

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.

2016 Q4

President Donald Trump

Does that look right to you yet?  The day after the election I sent a good friend of mine a message….”President Elect Donald J. Trump.  There.  Just had to give it a go and see if it feels more real.”  It didn’t really help.  Whichever side of the election you were on I think everyone can agree the concept of “President Trump” seems strange.  Yet on Friday, January 20th, 2017 Donald J. Trump was sworn in as the 45th president of the United States of America.  

In the weeks leading up to the election the news media was overwhelmingly predicting a Hilary Clinton victory.  Simultaneously, the financial news media was reporting that a Hillary Clinton election would be viewed positively by the financial markets whereas a Donald Trump election was sure to cause market chaos.  The actual results of the election and the subsequent reaction of the stock market were a reminder of how poorly the prognosticators prognosticate. As election night unfolded and the possibility of a Trump election became greater the futures market on the Dow and the S&P sank lower and lower.  But by the end of election week the Dow had posted its best week since 2011.  

By their fruits you will know them

It seems that a good portion of the news these days is spent on what “will” happen instead of what has happened.  Nowhere is this truer than in the financial media.  This time of year is full of forecasts: where the market will be at the end of the year; what direction interest rates will go; what sectors will out-perform, under-perform, etc.  After being an observer of these forecasts for more than a decade I can tell you the vast majority of them turn out wrong.  My favorite from last year: Bloomberg interviewed 65 analysts asking where interest rates would be at the end of 2016.  Every one of them said the yield on the 10 year treasury would be below 2%.  It closed the year out at 2.45%.  65 experts…all wrong.   

Every year I see similar forecasts from the experts and every year they fall short of being right.  When it comes to accurately forecasting the future the experts do not have a good track record.  But don’t just take my word for it…. Philip Tetlock is a professor who authored the book, Superforecasting: The Art and Science of Prediction.  He spent over 20 years interviewing 284 experts while tracking the accuracy of their forecasts along the way.  After compiling 20 years of data, here’s what he found in his own words: “the average expert was roughly as accurate as a dart-throwing chimpanzee.”

To be fair, Dr. Tetlock’s discovery does not disqualify all expert forecasting, as he makes clear in his book. What it does illustrate is the rarity of good forecasters.  Arriving at a correct understanding of current events is hard enough.  Then to take that and extrapolate what will happen next is extremely difficult.  There are always unknowns and there is always a human element, which is impossibly hard to predict – just ask the Baseball Prospectus guys.  Every year they run a simulation based on player and team statistics to predict each major league baseball team’s record.   In 2015, a team the system said would lose 90 games won the World Series (I’m not still bitter about that prediction…really, I’m not).  

In 2016 there was no shortage of incorrect forecasting.  The Presidential election, the Brexit Vote results and the subsequent market reaction from each of those events were all forecasted incorrectly by the vast majority of pundits on TV and the experts in the fields.  This brings us to a stark reality: most of the pundits on TV and the experts do not have a clue what is going to happen whether it regards the economy, politics or financial markets.  At the end of the day, all their running commentary is just a lot of noise.  

As investors, it is important to recognize the limitations on our ability to foresee future events.   We can’t predict with any accuracy where the market will be in six months or how we will get there.  Nor can we predict how one event – like the election – will impact the markets.  Pretending we can will result in making imprudent short-sighted investment decisions.   

However, that does not leave us blind and without a road map.  There are things we can know or have varying degrees of conviction through which we can make good decisions.  We can gather a lot of current factual information: economic growth rates, demographic trends, and government and private sector debt levels just to name a few.   We can have a general sense of where we are.  Economies and financial markets tend to move in cycles.  Economies move from contraction to expansion and vice-versa.  Markets move from euphoria to fear and back again. We cannot identify when a cycle will change but we can have a general idea of where we are. We can identify and evaluate various risks: geopolitical risk, economic risk, market risk, valuation risk, interest rate risk, and many other forms of risk.  

What this information will not do is tell us exactly what will happen over the next few months.  We cannot accurately forecast from this info where the S&P will be at the end of the year or what the yield on the 10 year treasury will be 6 months from now or how First Solar will perform over the next 3 months.  What we can do is use this information to make decisions regarding long term economic trends, current valuation levels, long term growth trends, short-term mispricing opportunities, conviction levels, allocation percentages, hedging needs and many other factors that go into building a diversified investment portfolio.  

Trumps Impact on Investing

As we look ahead to a Donald Trump Presidency the most important question we ask ourselves is not what impact President Trump will have on the stock market.  We don’t know how his presidency will ultimately impact the market and anyone who says they do is not being honest with you or themselves.  The real question to ask is what changes now that Donald Trump is President?  We would argue that the facts largely remain the same: the developed world is mired in too much debt; despite accommodating monetary policy of central banks (low interest rates and Quantitative Easing) economic growth is slow; productivity growth is stalled; the best long term growth opportunities still appear to be overseas; domestic assets – stocks and bonds – are at historically high valuations; and people will continue to eat food, drink water and use oil.  

What we will likely see from President Trump are policies that will have definite short term impacts.  For example, the tax policy proposed by the incoming administration will likely have a short-term benefit to corporations by lifting their profitability.  In addition, the administration is planning on infrastructure spending, which could have a positive impact on the general economy.   His foreign policy looks to be very different from past presidents which will adjust geopolitical risk.  His strong language against current trade policy and, more specifically, China will certainly have impacts on foreign markets.  But will any of these things substantially move the needle on the big picture items I stated above?  Probably not.  In our view, the Trump presidency does not completely change the landscape of investing.  It just shifts the shrubs around a little bit.  

The presidential administration may be changing but our focus on the long term remains the same.  The domestic portion of our portfolios will be conservatively allocated to value oriented portfolio managers or in sectors where we believe long term trends will prove out over short term volatility.  We will allocate positions to geographic areas where we believe there is good relative value, stronger growth potential and less debt.  Portfolios will have low exposure to interest rate risk.  Our focus on having non-correlating assets will also remain the same.  And we will continue to invest in areas where we see value and the greatest potential for long-term growth. 


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.