2017 Q4

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

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

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

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

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

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

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

Where are we? 

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

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

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

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

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

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

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

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

Blake

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.

2016 Q3 Quarterly Commentary

Interest Rates are Low?  Who Knew?  

The chart below shows the change in the interest rate of the 10 year Treasury bond over the last 34 years.  The early 1980’s were the tail end of a period of high inflation and interest rates.  Many of you probably remember having CD’s paying interest in the double digits.  In 1981 policies were enacted by the Federal Reserve that started a drop in interest rates that, as the chart below shows, has not really ended since.  Earlier this year the interest rate on the 10 year treasury hit a record low…the US has never seen interest rates this low.   In fact, if you put it in a broader historical context the current interest rate environment is the lowest the world has ever seen.  We won’t bore you with the details of Grecian, Roman, Byzantine and British Empire interest rates but it is true – interest rates have never been this low.  

The real effects of this on people’s lives are clearly visible.  On the positive side home, vehicle and unsecured financing is inexpensive.  This has allowed people to free up cash flow by reducing their interest costs and households have been slowly reducing their debt the last few years.  Total household debt relative to US Gross Domestic Product is the lowest it has been in over a decade. 

However, the negative consequences of low interest rates are starting to weigh heavily on investors and the economy.  Our economy is built upon a system of credit and interest and it is becoming apparent this system is impaired in a low rate environment.  Banks rely on the ability to lend money out for more interest than it costs them to hold it (net interest margin).  As interest rates entered into unprecedented lows their margins shrank and now depositors receive little to no interest while paying fees on their accounts.  Similarly, insurance carriers rely on interest payments from a bond portfolio to reduce premium costs and increase profits.  As income received from their investment portfolios have decreased insurance premiums have increased.  Pension funds who had generally counted on – foolishly in our opinion – an 8% annual rate of return to pay future liabilities are now facing a reality where 40% of their portfolio is only earning 2% – or less – interest.  That makes it kind of hard to earn the 8% they – and their pensioners – are counting on.  While low interest rates may have assisted in the avoidance of a total economic collapse if they continue too long our economic system may slowly break down.

What we think is more likely to happen is an attempt to return to normal via central bank raising interest rates. We have been waiting for this for a long time.  Admittedly, this low interest rate environment has lasted far longer and been more extensive, than we expected.  It could continue to go on longer than we expect.  But the commentary among the “economic and political elite” has begun to change.  The US Federal Reserve is receiving a lot of pressure to normalize rates and it appears they may resume that process soon.  

A World with Rising Interest Rates

This creates a very real risk to investors.  There is an inverse relationship between interest rates and the value of a bond.  If interest rates go down – like they steadily have for 30 years – then the value of a current bond goes up.  If interest rates go up then the value of a current bond goes down. Once this process of raising rates begins bond holders will be dealing with something they have not had to deal with in 30+ years – the value of their bonds going down.    

As Jack would remind us, the way people invested when he started as an investment manager 40 years ago this would not matter.   People would purchase a bond by directly lending the US Government or a company $10,000, for example, collect interest for 10 years and then at the end 10 years the entity would give them back their $10,000.  Whatever happened to the price of the bond along the way did not matter.  The investor got their $10,000 back at maturity no matter what the value of the bond did.  

But it does not really work like that anymore.  30 years of decreasing interest rates, an industry “scaling” their business models to maximize profits, and the creation and adoption of Modern Portfolio Theory (the en-vogue investment management theory of the day) have essentially changed how individual investors access the bond market.  Investment products have been designed and built around a bond market that steadily increases in value. The principal protection element of bonds (you get your $10,000 back the end of 10 years) has been at best limited and at worst eliminated through the management style of bond funds.  Bond fund managers rarely (very rarely) hold a bond till maturity.  In fact, the execution of a portfolio following Modern Portfolio Theory results in the creation of divided bond classes grouped by the maturity date of the bond.  This grouping forces the manager to sell their bond holdings prior to maturity, even it has to be sold at a loss. 

With the winds of change upon us we are being forward thinking in how to manage a bond portfolio in a rising interest rate environment.  There are methods to mitigate this risk.  Some strategies have already been implemented in portfolios and others will be implemented as conditions warrant. 

China

In the 2016 Quarter 1 commentary we wrote the following:

The Chinese market and economy have made a lot of headlines over the past year.  The Shanghai Exchange experienced massive volatility in 2015 and the resultant conversation of the financial pundits was that the Chinese economy was headed for a hard landing.  We have never quite understood the general consensus of the financial world towards China.  They have painted a picture of a country laden with debt, lower economic growth prospects, and highly overpriced stock markets (sounds familiar).  But to every one of these arguments there exists fundamental misunderstandings about China.  In the interest of brevity, let’s examine just one…overpriced stock markets.

In the Quarter 1 commentary we addressed the overpriced stock market.  In the Quarter 2 commentary we addressed lower economic growth prospects.  And this quarter we will wrap this up by addressing the misconceptions of China being overextended in debt.  

Wait a minute…there’s actually two sides to a balance sheet?  

During the last decade total debt in China – consisting of corporate, household, government and bank debt – has increased from roughly 150% of China’s Gross Domestic Product (GDP) to over 250% of China’s GDP.  That’s a lot of debt. In fact, when you take into consideration that the denominator in the equation has also increased significantly during that time period the increase in debt gets really big: total debt has gone up 465% in the last decade.  

Our recent experiences in western culture make these numbers very worrisome.  In the US, we have witnessed the danger of an over-leveraged economy: the 2006 housing crisis and the subsequent Great Recession beginning in December 2007.  But to every balance sheet there are two sides: assets (what you own) and liabilities (what you owe).  What is being largely ignored in the case of China is the asset side of the balance sheet.  

Let’s take a look at the household debt burden in China within the context of the real estate market.  In the last few years many pundits have expressed concern of a growing bubble in Chinese home prices.  Home prices have increased roughly 9% – on average – every year for the last 10 years.   In our economy those high increases would be troubling.  But Asian cultures tend to look at savings and debt differently than western culture.  In short, they save more and they go into less debt. A few statistics to consider:

  • Wage increases have averaged roughly 13% per annum for the last 10 years, which outpaces the home price increases.
  • In order to buy a home in China a 20% down payment is required.  That is not a banking standard.  It is a law.  That is if it is your first home.  If you are buying an investment property (second home) 30% is required. 
  • A 2014 study showed that 15% of all real estate purchases were paid with 100% cash.
  • According to a China Household Finance Survey in 2012, average household debt amounted to only 11% of home value; the median household debt was 0%.   
  • The same 2012 survey indicated that if home values fell 50% only 14% of mortgages would be underwater.  

Those stats paint a very different picture than an over-extended, over-leveraged consumer.  And a similar picture could be painted for corporate and government debt: there are assets to support their level of debt.  Even the structure of the debt (state financed in a closed system) makes the debt level more palatable.  While Chinese debt has grown excessively during the last several years it appears to be at manageable levels. 

That is not to say there is no risk here.  In our opinion this increase in debt is going to continue for some time.  China has aspirations for their currency (Yuan) to be used more heavily in international transactions and as a reserve currency.  In order for that to happen there needs to be more volume of Yuan in the market.  In a fiat currency system, money is created and put into circulation through debt.  If China wants more Yuan in circulation then more debt will be required.  Continuing to fuel this debt may put more strain on the Chinese economy.  While we do see long term value in investing in China we will be closely monitoring the situation watching for meaningful economic deterioration. 

As we examine the global landscape, China – and other select Emerging Markets – continue to have the greatest potential for long term growth.  We believe patient investors who endure the volatility often experienced in these markets will see long term gains.  We also see developed markets – such as the US and Europe – struggling to obtain meaningful economic growth.  As central banks and governments make more decisions and businesses and individuals continue to adjust to an economic environment very different than it was a decade ago we believe markets will continue to be volatile.  Throughout these developments we will continue to invest in areas where we see value and the greatest potential for long-term growth.

Blake

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.

All Quiet on the Western Front

After nearly two years of relative uncertainty, marked with brief moments of extreme pain, U.S. equity markets are enjoying a long run of relative calm. The S&P 500 has now posted 5 months in a row of positive returns and is up 7.66% through the end of July. Over the same time period the venerable Dow Jones Industrial Average has produced a 7.38% total return, with dividends reinvested.

Despite these figures, satisfaction lies far away, lounging without a care in the world for us. Anxiety runs higher than average as the collective heart of our collection of hearts seems to skip a bit with each new blurb, soundbite, earnings release, and blogpost (not this one, of course). One could very reasonably assume that up markets should produce up feelings. Very often they do. Yet our feelings are not so peppy, but rather taut like a violin string played very high for just long enough to snap. Consider:

If we look to our left, we see a broken European system forging ahead as if nothing is amiss. Unemployment rates in Spain remain at 20%, above 12% in Italy, and still in double digits in France. On our right we see a burgeoning domestic debt load, growing like a Greek tragedy with a terrific 2nd act (“Hello Entitlement Benefits! We thought you’d gone away while our heads were in the sand!”) And, if we get down on our bellies and squint just a bit, we can see the teeny-tiny interest building in our savings accounts. 800 pennies for 1,000 dollars should be the name of a Gaelic soul band, not the annual interest on our savings accounts.

What should we conclude from these competing weathervanes? Are the positive returns enough to keep the system going or will economic realities begin to cave in? Can financial optimism overcome economic realism?

A bellicose reader might observe that markets are always fraught with uncertainty, making today’s circumstance unexceptional. He might continue that the nearly unlimited universality of information brought about by the internet has made it fashionable to always be pessimistic. After all, the world is a big place, there must always be something wrong somewhere.

And, perhaps, he is right. But, perhaps, that’s only because we are asking the wrong question. Instead of asking whether or not we should be purchasing new investments, we should be reminding ourselves of timeless principles. Those truths that remain relevant in all circumstances.

We should remind ourselves of one such truth today, during a brief respite from volatility. In periods both of rosy returns and unending losses, it remains true that there are things you can control and things you cannot. Maintaining a steady eye on both makes all the difference. Markets have gone up. Good! I must realize that I did not make it so. Markets have gone down. Oh no! I must accept that I did not make it so.

If we do not accept that we cannot control markets, we are destined to be controlled by them. Conversely, if we accept that we hold no sway over the market’s whims, we can decide what it is that we would actually like to own. When we know what we own and why we own it, we can confidently move forward as prudent investors.

As is oft repeated, but not digested nearly enough: We will continue to look for opportunities to invest capital consistent with an acceptable level of risk.

JKIII

A $65,000,000 Deceased Eagle? The Subjective Nature of Value

In 2007, an art dealer/collector by the name of Ileana Sonnabend passed away. Within her rather large and valuable art collection – her net worth was estimated at $1 billion – was a piece titled, Canyon. The artist, Robert Rauschenberg, used a combination of paint, sculpture and a stuffed juvenile bald eagle in constructing the piece. When I say a stuffed bald eagle I’m not talking a stuffed animal you’d buy your kid to snuggle with. This was an actual taxidermied eagle.

In the audit of Sonnabend’s estate tax return the IRS noticed this prized piece of art had been valued at $0.00. While that may seem strange it was with good reason. In 1940 congress passed the Bald and Golden Eagle Protection Act making it illegal to possess, sell, purchase, transport, import or export a bald or golden eagle in any condition…dead or alive. Ms. Sonnabend had been granted permission to retain her ownership of the piece as long as it was on display at a public museum but it was illegal for her estate to sell it.

What’s the worth of something you can’t sell? The valuators of the estate argued it was $0.00. The IRS on the other hand came to a valuation of $65,000,000, which came with a $40,000,000 tax and penalties bill (see here for NY Times article).

Two different groups looked at the same set of facts, the same circumstances and came up with valuations that were $65,000,000 apart. How can that happen? Each side had reasons for their figures but let’s not get lost in details. From a big picture standpoint it happened because valuations are subjective. They require assumptions. They require individual opinions.

Take a dental practice valuation for example. There are a number of subjective elements to a dental practice valuation. If the valuator utilizes a cash flow method they have to make decisions on what to include as add-backs to net cash flow. There’s no standard to that (at least not one I can agree with) and what and how much of what gets added back in is up to debate. And that’s only the beginning. How do you figure replacement value? What about the capitalization rate, which is partly a product of intangibles like location.

You may or may not be familiar enough with valuation lingo to know exactly what I’m talking about but I’m sure you see my point…when you look at a practice valuation you see an opinion derived through a lot subjective decision making. Give two different valuators the same info and you are likely to get two different answers. Add a third and I’m sure we could all guess the result…a different number.

That’s not to say valuations are meaningless. They do have value. But the figures shown should not be viewed as sacrosanct and in a merger or acquisition the value figure should not be solely relied on to drive price. What does matter? The answer is dependent on whether you are the seller or the buyer. Let’s start with the seller.

Have you ever watched the Antique Roadshow or at least seen a clip of the show? Ever noticed what the experts say when they are giving a dollar figure to the person who brought in the 18th century Chinese rhinoceros horn cups (really). In this specific instance they state auction value. At other times they state retail value or insurance value. There’s differences in those definitions but all of them revolve around the same concept – how much money someone will pay the owner to part with the item. For the seller of a dental practice, that’s what matters. How much you can get for the practice.

What a buyer should be looking for is the return on investment. The value of dental practices is almost entirely made up in their cash flows. The assets of the business have little value (secondary market equipment value is much much much much much lower than new purchase cost). The “asset” with the greatest value is goodwill but the value of goodwill is usually derived from the cash flow of the business which brings it back around to cash flow being the predominant driver of value. What a buyer needs to be concerned about is what kind of cash flow they will receive from the practice and what risks exist to the sustainability of that cash flow.

Do not get too attached to valuations. If you are selling a practice, use it to assist you in establishing an asking price. If you are a buyer, use it as a starting point to determine what return on your investment you could expect to receive.

Blake