Monthly Archives: May 2017

Covenant Weekly Market Synopsis as of May 26, 2017

May 30, 2017

Equity markets remained resilient in a week of potentially negative market-moving headlines: a terrorist bombing in the UK, a downgrade of China’s credit rating, and a Federal Reserve announcement for plans to begin reducing its balance sheet later this year. Domestic stock indices such as the S&P 500 and Nasdaq ended the week at record highs after advancing 1.5% and 2.1%, respectively. Year-to-date, the S&P 500 is up 7.9% (ex-dividends), but 5 stocks are responsible for more than half of the year-to-date gains in the S&P 500 (see Market Internals below). Developed international equity markets tacked on modest gains for the week, but remain about 1% ahead of domestic stocks month-to-date (up approximately 2.5%). Emerging (+1.9%) and Frontier Market (+1.1%) equity indices moved higher, pushing YTD gains to 18.4% and 13.9%, respectively. Interest rates on US Treasuries ticked higher on the week, but yields on the long end of the curve (10-year and 30-year bonds) remain lower on both a month-to-date and year-to-date basis. As of Friday, the yields on the 10-year and 30-year bonds were 2.25% and 2.91% (as compared to 2.44% and 3.07% on January 1, 2017). In the commodity complex, precious metals rose, while copper and crude prices declined, with WTI Crude closing the week at $49.87 per barrel. The VIX Index (a measure of expected S&P 500 index volatility) fell below 10 again last week (vs. a long-term average of 20), highlighting investors’ beliefs that the road ahead will continue to be smooth.

For a detailed view of weekly, month-to-date and year-to-date asset class performance please click here.

 

Q1 GDP Update: The estimate of real, annualized GDP output was revised up from 0.7% to a better than anticipated 1.2%. Despite the upward revision, Q1 growth was still weak, just not as weak as originally believed. Corporate profits for the first three months of the year fell by 1.9% quarter-over-quarter, but were 3.7% higher than one year ago. The variance between a quarterly decline in corporate profits and the high number of companies that beat consensus earnings estimates in the first quarter may seem irreconcilable. However, share repurchases (financed through cheap debt) have reduced the total number of shares outstanding. Hence a company can have lower total earnings while still reporting improved earnings on a per share basis as there are fewer shares over which to spread those earnings (for a more detailed explanation see Weekly Synopsis March 31st). Consumption growth was revised up to 0.6% (from 0.3%), but still contributed less to quarterly growth than at any point in the last two years (see chart below). On the other hand, business investment growth (as a % of GDP) was the best it has been in the last 9 quarters, and was revised higher to 11.4% annualized, from 9.4%. Thus far, second quarter economic data has been mixed suggesting that the Q2 GDP growth may not be as strong as anticipated by the market. This coming week will be data heavy with income, consumption, PCE Inflation, and May payrolls providing a clearer picture of the current state of the economy. Though we expect Q2 growth to exceed 2.5%, we do not see any evidence that the economy is on the cusp of sustainable, accelerating growth. Our baseline forecast is that the economy will remain “good, but not great” with annual, real GDP growth averaging 2% – 2.5%.

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Market Internals: According to Bespoke Investment Group, just 5 stocks are responsible for more than half of the year-to-date gains in the S&P 500. Apple, Facebook, Amazon, Microsoft and Alphabet account for 4.6% of the 7.9% percentage-point gain in the S&P 500 year-to-date. It is also worth noting that “growth” stocks are dramatically outperforming “value” stocks thus far this year. Within the S&P 500, growth stocks have gained 12.9% year-to-date, whereas value stocks have moved higher by a mere 2.2%. The divergence between growth and value stocks, along with index gains largely resulting from the performance of only 5 stocks, makes this a challenging environment for active managers except for those focused on momentum investing styles.

 

Lower performance, higher returns?: The torrid pace of gains exhibited by growth stocks (and the five stocks listed above in particular) can cause anxiety amongst some investors. “FOMO”, the Fear Of Missing Out, is a powerful emotion and can result in poor investment decisions as investors buy what has gone up recently.  It is worth remembering the adage that successful investing is a marathon, not a sprint. On a longer timeline, a disciplined and diversified investment strategy can lead to dramatically improved performance, even if that strategy “underperforms” over certain time periods. For example, since 1928, the S&P 500 has produced annualized returns of 9.3%. Though investors have had to contend with multiple drawdowns of 50% or more, those investors that hung in there were rewarded. Sadly, most investors did not realize those gains. A preponderance of academic research shows investors tend to sell at market lows and buy at market highs, greatly reducing their portfolio’s performance. One of the most striking examples of this phenomenon is Peter Lynch’s Magellan fund. From 1977 – 1990, the Magellan fund generated compounded growth of +29%, but research by Fidelity revealed the average investor in the fund lost money(!!!) as market volatility caused investors to both sell and buy the fund at the wrong time.

By contrast, diversifying a portfolio can lead to lower overall volatility, an improved investment experience and improved investor performance. Charlie Biello, director of research for investment advisory firm Pension Partners, provided evidence of the efficacy of this approach. He shows that a more stable portfolio that captures 65% of the upside of the S&P 500, and limits losses to 31% of the market’s downside, outperforms the index in the long run. This diversified “Stable” portfolio generated annualized gains of 12.9% since 1928, or more than 3.5 percentage points per year on average than a buy-and-hold S&P 500 strategy. The table below highlights the change in value of a hypothetical $10,000 investment in the two portfolios.

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Over the 90-year period of the analysis, the Stable portfolio generated gains nearly 1,700% higher than the S&P 500. This same Stable portfolio would likely be criticized as underperforming over the last several years vs. a concentrated S&P 500 investment. Yet, history is on the side of this strategy outperforming in the long-run. The bottom line is that successful, long-term investors don’t succumb to the siren-call of FOMO and maintain a disciplined investment approach.

Be well,

Jp.

Covenant Weekly Market Synopsis as of May 19, 2017

May 23, 2017

Last week a branch snapped in the forest… waking the hibernating volatility bear. Jumping to all fours, teeth bared, ready to attack. The groggy bear surveyed the landscape, listening intently while sniffing the air for even the slightest scent of trouble. Carefully camouflaged under promises of tax reform, deregulation and fiscal stimulus the volatility bear detected nothing amiss in the wide gap between investors’ expectations and actual hard economic data. He shrugged, walked in a circle, flopped back down on the ground, yawned and went back to sleep… extending what is becoming a historically long winter nap. Some day he will wake, but it was not to be last week. On Wednesday, when the branch snapped, equities suffered their worst one-day loss since BREXIT with the S&P falling 1.8% and global equities declining 1.2%. The VIX Index (a measure of expected market volatility) jumped 46% to 15.59, albeit off a low base of 10.65 the day before. The next day equities resumed rally mode, recovering much of the losses and ended the week with a modest decline of less than 1%. The VIX Index promptly fell back to 12.04, a value that is well below the post-Financial Crisis average of 17.6 and the longer-term average of 20.

Looking beyond the fireworks of the stock market, the bond market may be sending a clearer signal. The U.S. Treasury Yield curve flattened further last week as the yield on the 10-year declined by 9bps (0.09%), while the 2-year note yield fell only 2bps. At 96bps, the spread between the 10-year and 2-year notes is now back to about where it was prior to the Presidential election. Historically, a flattening yield curve indicates the market expects lower growth, interest rates and inflation.

For a detailed view of weekly, month-to-date and year-to-date asset class performance please click here.

Best Laid Plans: When the Federal Reserve raised interest rates in December 2016 and then again in March 2017 it served two purposes:

  • Initiated the rate normalization process. The Fed’s hope/forecast is to raise short-term rates to 3% so that they will have “dry powder” for the next recession.
  • Tightened monetary policy to temper what the Fed views as potentially building sources of inflationary pressures in the economy. The Fed is especially concerned about the low and falling unemployment rate, which they fear will generate wage-push inflation resulting from an overly tight labor market.

This is standard monetary policy strategy – tighten when the Fed believes the economy is on a path toward overheating and loosen when the economy is flagging. Yet a funny thing happened on the way to tightening monetary policy…. measurements of financial conditions in the U.S. have become easier, not harder, frustrating the Fed’s efforts.

Covenant Weekly Market Synopsis as of May 19, 2017

May 22, 2017

Last week a branch snapped in the forest… waking the hibernating volatility bear. Jumping to all fours, teeth bared, ready to attack. The groggy bear surveyed the landscape, listening intently while sniffing the air for even the slightest scent of trouble. Carefully camouflaged under promises of tax reform, deregulation and fiscal stimulus the volatility bear detected nothing amiss in the wide gap between investors’ expectations and actual hard economic data. He shrugged, walked in a circle, flopped back down on the ground, yawned and went back to sleep… extending what is becoming a historically long winter nap. Some day he will wake, but it was not to be last week. On Wednesday, when the branch snapped, equities suffered their worst one-day loss since BREXIT with the S&P falling 1.8% and global equities declining 1.2%. The VIX Index (a measure of expected market volatility) jumped 46% to 15.59, albeit off a low base of 10.65 the day before. The next day equities resumed rally mode, recovering much of the losses and ended the week with a modest decline of less than 1%. The VIX Index promptly fell back to 12.04, a value that is well below the post-Financial Crisis average of 17.6 and the longer-term average of 20.

Looking beyond the fireworks of the stock market, the bond market may be sending a clearer signal. The U.S. Treasury Yield curve flattened further last week as the yield on the 10-year declined by 9bps (0.09%), while the 2-year note yield fell only 2bps. At 96bps, the spread between the 10-year and 2-year notes is now back to about where it was prior to the Presidential election. Historically, a flattening yield curve indicates the market expects lower growth, interest rates and inflation.

For a detailed view of weekly, month-to-date and year-to-date asset class performance please click here.

 

Best Laid Plans: When the Federal Reserve raised interest rates in December 2016 and then again in March 2017 it served two purposes:

  • Initiated the rate normalization process. The Fed’s hope/forecast is to raise short-term rates to 3% so that they will have “dry powder” for the next recession.
  • Tightened monetary policy to temper what the Fed views as potentially building sources of inflationary pressures in the economy. The Fed is especially concerned about the low and falling unemployment rate, which they fear will generate wage-push inflation resulting from an overly tight labor market.

This is standard monetary policy strategy – tighten when the Fed believes the economy is on a path toward overheating and loosen when the economy is flagging. Yet a funny thing happened on the way to tightening monetary policy…. measurements of financial conditions in the U.S. have become easier, not harder, frustrating the Fed’s efforts.

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Source: BCA Research

 

The explanation for the easing financial conditions is that adjusting interest rates is a rather blunt monetary policy tool. Moreover, monetary policy is only one of several factors that drive the “looseness” or “tightness” of financial conditions. Credit spreads (i.e. the cost of capital above U.S. Treasuries), stock market performance, and the value of the U.S. Dollar also figure into the calculation. Since the Fed began hiking in December, credit spreads have tightened (reducing the cost of capital for corporations and individuals), the stock market has risen and the US Dollar has weakened (improving the competitiveness of U.S. goods and services exporters). In other words, the Fed’s policy actions have been ineffective thus far.

Of course, these inputs are interrelated. And as sure as the sun will rise tomorrow, if the Fed continues to raise rates they will eventually tighten financial conditions and put the brakes on economic growth. Barring an exogenous event (e.g. natural disaster, war, or major terrorist event), they will likely continue to do just that and this economic expansion will end like so many before it with the Fed overshooting the sustainable interest rate level and choking off economic growth to a degree that pushes the economy into a recession. It may not happen this year or even next year, but business cycles are not extinct. The Fed can try to temper the cycle’s amplitude on both the upside and the downside, but they cannot prevent the inevitable.

 

Staying Power: When an entrepreneur starts a business, she/he is generally donning rose colored glasses in which the future is full of opportunity. However, most entrepreneurs fail to account for the large role that chance plays in their success. Even great management teams can sometimes fall victim to bad luck that kills a once successful business. On the other hand, some companies can survive the bad times and thrive in the good ones through a combination of chance and great leadership. The U.S. was built on the entrepreneurial spirit, beginning with the country’s forefathers creating a new government structure that produced democratic rule. The entrepreneurial spirit has never died and, in fact, has played a key role in our country’s global economic dominance (along with abundant natural resources and a geographically defensible locale). So, in recognition of the great entrepreneurs of our country, the infographic below (courtesy of Visual Capitalist) shows the oldest companies in each state. Surprisingly, most of the oldest businesses are not household names, outside of a few exceptions (such as Imperial Sugar in Texas and Jim Beam in Kentucky). Another unexpected feature of this infographic is the high representation of pubs, inns and restaurants – businesses with a notoriously short expected lifespan.

 

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Be well,

Jp.

Covenant Weekly Market Synopsis as of May 11, 2017

May 15, 2017

Thus far in May, domestic equity indices have been consolidating with the DJIA, S&P 500 and Nasdaq hovering near record highs. Developed international stocks have fared better for the month and the year – as have emerging and frontier market equity indices. Corporate earnings per share for the first quarter in the U.S. are showing a marked improvement, rising +14.7% from a year ago. The energy sector is a notable standout, with earnings growth of 641.2% since Q1 2016 (source: Thomson Reuters) when the price of oil was bottoming around $26 per barrel. Having recovered to nearly $50 per barrel at the end of Q1 2017, the energy sector is no longer in recession. The market appears to have anticipated the earnings improvement as investors have taken their foot off the accelerator the last 1.5 months after buying with both hands in January and February. Interest rates on US Treasuries remain largely range bound as recent economic data (a lower unemployment rate than expected, combined with lower inflation) did not interrupt the market’s view that the Fed will raise rates again in June. Precious metals posted modestly higher prices for the week, but remain down for the month (Gold -3.1% and Silver -4.3%). The US Dollar moved higher by 0.5% for the week, but remains down 3% year-to-date. Finally, the VIX Index (a measure of expected market volatility) declined 1.6% last week and has fallen nearly 26% year-to-date to 10.4 (vs. a longer-term average of approximately 20.0).

For a detailed view of weekly, month-to-date and year-to-date asset class performance please click here.

Investment Lessons from the Masters of the Universe:  This is a little geeky, but try to stick with it as it includes valuable lessons from some of the greatest investors of all time. Factor exposures, while long understood (and pursued) in the hedge fund industry, have gone mainstream in recent years through the launch of a multitude of “smart beta” investment products. Whereas traditional strategies track a specific benchmark index (e.g. S&P 500, Nasdaq, Russell 2000, etc.), “smart beta” strategies focus on one or more investment factors (e.g. Value, Size, Quality, Momentum) that have historically produced enhanced risk-adjusted returns over traditional benchmark indices. There is a vast amount of academic research supporting smart-beta advocates’ claims that a rifle-shot approach to selecting stocks that possess certain factors will deliver comparable, if not better, returns with lower risk than passively investing in a capitalization-weighted index (e.g. the S&P 500). This remains an area of intense interest for investment managers as well as investors who are increasingly adopting this approach for at least a portion of their investment allocations.

Pursuing certain types of factor exposures is not new, in fact it is often referred to as an investment style. Yet, today we have better tools to analyze factors and measure their impact on a portfolio’s performance. AQR Capital Management, a leading quantitative investment firm, recently presented research analyzing the investment track records of several famous investors. Each of these investors is outspoken about their investment style and thus AQR’s research was designed to verify if the investor’s results matched their stated style. The results of the research are interesting in that they deliver transparency into what enabled these investors to become Masters of the Universe.

Although AQR’s research paper discusses four different investors, for the sake of brevity, only one example is included here.

Warren Buffett – Berkshire Hathaway(BRK)

From January 1977 to May 2016, BRK produced annualized performance of 17.6% vs. 6.9% for the stock market (measured as excess returns over cash). How did Mr. Buffett generate 10.6% annualized outperformance over this nearly 20-year period? Quoting Mr. Buffett in 2008, “Whether we’re talking about socks or stocks, I like buying quality merchandise when it is marked down”. There is no doubt that Mr. Buffett likes a bargain, but what is not as well understood is that BRK also benefitted from cheap leverage from its insurance business. The leverage enabled Mr. Buffet to put approximately $2.30 cents to work in the market for each $1 of BRK equity. Additionally, when evaluated against well-known factors, Buffett’s performance is less mysterious. Of the 17.6% annualized performance, only 3.6% of it (termed “Regression Alpha”) is unexplained by four common factors of Quality, Low-Risk, Value and Market.

Berkshire Hathaway Stock  (Jan 1977 – May 2016)

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Source: AQR Capital Management

In other words, the clear majority of Berkshire’s returns were generated from leverage, the general movement of the market, and to a lesser extent, identifying high-quality, bargain stocks. That’s not to say Mr. Buffett is not a great investor, but what makes Mr. Buffett great is not what is commonly reported.

AQR’s research also analyzed the track records of Bill Gross (PIMCO Total Return Fund), George Soros (The Quantum Fund), and Peter Lynch (The Magellan Fund). As with Buffett, most of the performance for each manager can be explained by persistent exposure to identifiable factors that have historically produced excess returns. These managers deserve some credit as many of these factors were not widely understood nor documented when they produced their market-beating performance. These Masters of the Universe essentially figured them out on their own, which was a key ingredient to their success.

An even more important aspect to their success is that Buffett, et al. remained disciplined in their investment process. Despite numerous setbacks in which these long-term factors underperformed (Berkshire’s stock fell more than 50% on two occasions during the study period), they stuck to their respective investment plans and over the long-term produced some of the best track records in the history of investing. Regular “Joe’s/Jane’s” like the rest of us can learn from their approach. The first lesson is to maintain a diversified portfolio so you can weather inevitable periods of underperformance. The second lesson is to stick with your investment plan.

Be well,

Jp.

Covenant Weekly Market Synopsis as of April 28, 2017

May 1, 2017

April was a short, two-act play in which our favorite protagonist, equities, ultimately moved higher. In the first act, geopolitical tensions (e.g. North Korea/China and Syria/Russia), weaker economic data and the French Election generated a modest sell-off in risk assets. In the second act, improved corporate earnings and anticipation of tax reform overcame still weaker economic data to push domestic equity indices higher. Developed international and emerging markets followed a similar narrative, taking their lead from US stocks. When all was said-and-done, global equities rose a little more than 2% with international stocks outpacing domestic stocks.

For the month, Treasury yields pushed a touch higher on the short end of the curve, but declined at the longer end of the curve (i.e. the yield curve flattened), signaling that bond investors are skeptical of the “reflation trade” catalyzed by President Trump’s election. Precious metals were mixed with gold (+1.5%) recording gains for the fourth consecutive month, while silver declined nearly 6%. The price of WTI Crude fell for the second straight month to close at $49.18 per barrel. The US Dollar declined by 1.3% (it has fallen in 3 of the last 4 months) and is down 3.1% year-to-date. All else being equal, a weaker US dollar improves relative performance of international equities and makes U.S. products and services more competitive (owing to a lower relative cost) internationally.

For a detailed view of weekly, month-to-date and year-to-date asset class performance please click here.

Sentiment vs. Reality: A topic covered in this blog over the last several months and in our last two quarterly Economic Review and Outlook letters (the Q1 letter distributed last Friday is available here), is that President Trump’s election has absolutely stirred the animal spirits. Measures of sentiment, such as the Small Business Optimism Index, the Consumer Confidence Index and the ISM Manufacturing Index values rose impressively following his election. Yet, improved animal spirits have yet to translate into real activity. As a result, the economy remains largely in the same state as before the election, even as risky assets have moved higher in anticipation of improved economic conditions.

How far have animal spirits gotten ahead of the economy? The following two charts compare sentiment to real economic activity. The chart immediately below shows the ISM Manufacturing Index (a survey of approximately 300 supply management professionals) vs. new orders and shipments.

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Sources: Institute for Supply Management, US Census Bureau and FTN Financial.

This next chart highlights consumer confidence (the blue mountain) as compared to the sequential change in quarterly consumption growth (the gray line).

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Sources: Bureau of Economic Analysis, Conference Board and Bloomberg.

The rise in sentiment is understandable. For the first time in at least eight years the President of the United States has declared his primary focus will be on jobs and business. This message has inspired confidence, but little activity — highlighted in these charts by the gap between sentiment and reality. This sentiment/reality gap can be closed in one of two ways: reality rising to meet sentiment or vice versa. For the former to occur, Congress and the administration need to find common ground to begin implementing pieces of President Trump’s agenda. If they don’t, sentiment will decline to meet reality. Thus far there have been no solid indications that congress will support any of Trump’s agenda. Absent meaningful progress in the next few months look for sentiment indices to return to their pre-election levels, or worse, and for risk assets to follow suit.

Be well,

Jp.