Monthly Archives: December 2017

Domestic stocks closed the week at record levels as likely tax reform and positive economic data (November retail sales +0.8%) propelled stocks higher. The S&P 500 tacked on gains of 0.9%, while the tech-heavy Nasdaq rose another 1.4%. International stocks, on the whole, gained 0.6% even as European and Japanese regional stock indices declined (-0.3% and -1.7%, respectively). Interest rates on the front-end of the U.S. Treasury curve rose, while those on the back-end fell, resulting in additional curve flattening. For the first time in nearly a decade, the yield on the 2-year US Treasury now exceeds the S&P 500’s dividend yield (source: Liz Ann Sonders, Charles Schwab). Precious metals gained (gold +0.6%, silver +1.2%) and copper (an important industrial commodity) rose 5.2%. WTI Crude declined a modest -0.1% to close the week at $57.30 per barrel.

It’s also worth noting that the Fed increased its Federal Funds Target rate by 0.25% (to 1.25% – 1.50%) as expected last week. In response, China’s central bank (the People’s Bank of China) raised their short-term money market rates by 0.05%, ostensibly to discourage investors from seeking to export their capital (if they can get around China’s strict capital controls) to the U.S.

For more detail on weekly, month-to-date and year-to-date asset class performance please click here.

Saint Nick – Tis’ the season for ugly sweaters, family gatherings, eating too much, and….higher equity prices. Since 1896 the Dow Jones Industrial Average has risen 76% of the time between the day after Christmas and the first two trading days in January gaining an average 1.5% (source: Hulbert Financial Digest). This compares to stocks rising only 55% of the time during all rolling six-day periods throughout the year. While stocks failed to rally over this timeframe in 2 of the last 3 years, current momentum makes it a good bet that the Santa Claus rally will be part of the 2017 stock market story.

Great Expectations – Expectations are a funny thing. By definition, expectations are related to some event or outcome in the unknowable future. And they are shaped by previous experiences, with the most recent experiences having an outsized impact on one’s perspective. The process by which expectations are formed is the basis for a well-documented behavioral phenomenon called recency bias. Recency bias is why people believe that an NBA player who has made several shots in a row should be fed the ball continually… because he has the “hot hand”. In investing, recency bias leads one to believe that the recent market action is predictive of the future. This can lead to poor investment decisions when the actual market action diverges from the expected market action. Recency bias can be addressed by studying the past (be it basketball or stock markets) to understand when recent events are an anomaly relative to history. With that in mind, the chart below highlights the unique character of the 2017 financial markets when viewed through the lens of risk-adjusted performance. It has been a year of solid gains with incredibly low volatility. In fact, unless something changes in the next two weeks, 2017 will be the least volatile year in the history of stock markets. To put this chart in perspective, the long-term Sharpe Ratio of the S&P 500 is approximately 0.3, meaning that in 2017 the S&P 500’s risk-adjusted performance is 10x better than its long run average. [Note: the Sharpe Ratio is calculated from the average return of an asset less the risk-free rate divided by the standard deviation of returns for that asset.]


This chart does not imply stocks will decline in value next year. While falling stock market prices is always a possibility, it is a surer bet that the volatility of stock prices will be higher. The bottom line is that investors should not be lulled into complacency by the market’s tranquility in 2017, nor should they overreact in response to more normalized volatility levels.

Is Santa real? – So began the conversation with our 9-year old boy.  It was the beginning of the same conversation we had last year, only then we sidestepped the question and he got distracted and moved onto playing with his Legos.  But this year he was insistent.  At first, we played dumb…  feigning ignorance and acting bewildered by his question.  But he was relentless.  Finally, we showed weakness and asked “Why do you want to know?”  He sensed blood and went in for the kill “For two reasons”, he responded:

  • “First, it’s a good idea for parents to say Santa is real because it forces kids to be good, or not get presents.  So that makes me wonder.”
  • “Second, if Santa is real, I’ll ask for really expensive stuff [darn Internet feeding his brain with ideas and $-signs] because Santa and his elves can make them for free.  If Santa’s not real, I don’t want my family to buy me expensive gifts.”

His first point was logical and insightful.  It’s true, Santa is a great trump card for parents to play with mischievous children as Christmas draws near and suddenly he understood that.  His second point exhibited financial awareness. My wife and I looked at each other and, without exchanging words, we knew it was time. Clearly, he is beginning to see the world through a more mature lens. So, we told him the truth… reluctantly sacrificing another little bit of his childhood wonder (the Easter Bunny and the Tooth Fairy are long dead and buried).  Our admission came with a warning. We told him how special this information is and that he should never share it with another child because they might believe and the importance of not robbing them of that belief.  

We’ll see how Christmas goes this year.  We thought that by revealing the Santa truth he and his sister might sleep in a bit on Christmas. But our own little Christmas wish probably won’t come true as he’s already asking if 4am is too early to get up on Christmas morning to open presents. So, as we turn the page on a new type of Christmas in our home, one without Santa, we wish you a heartfelt Happy Holidays.

See you again in 2018. Until then, be well.


After stumbling out of the gates in December (typically a very good calendar month for stocks), equities regained their footing over the last couple of days tacking on gains of 0.4% to close out the week at highs (at least for the S&P 500 and Dow Jones Industrial Average, though the Nasdaq is not far off). International stocks were mixed on the week with Europe putting in the largest gains (+1.5%), followed by frontier markets (+0.6%) and Japan (+0.5%). There were a few losing indices on the week, but losses were generally muted as China’s main index fell 0.4% and emerging markets gave back 0.5% (but remain up 31.7% year-to-date). Yields pushed higher on the front end of the curve, while the long-end (i.e. 30-year maturity) US Treasuries barely budged, causing a flattening in the yield curve described in more detail below. It was a rough week in the commodity index as the prices of precious metals (-3%), copper (-3.7%), and crude (-1.8%) all fell. The US Dollar climbed for the second consecutive week as progress on tax reform and reasonably solid economic data should keep the Fed on track to continue raising interest rates, including a 0.25% increase when they conclude their final meeting of the year this Wednesday.

For more detail on weekly, month-to-date and year-to-date asset class performance please click here.

The Yield Curve is Flatter – so what? As interest rate differentials between 2-year and 10-year US Treasuries (“USTs”) have declined, media coverage and Google searches for the term “yield curve flattening” have increased dramatically. It seems that the ongoing flattening of the yield curve is one of the top concerns of investors who see this as a sign that the economy is beginning to sputter. To be clear, the concern is not so much that the yield curve is flattening, but that the interest rate differential will continue to decline resulting in an inverted yield curve (i.e. the yield on UST’s maturing in 2 years become higher than the yield on USTs maturing in 10 years). Inverted yield curves have a fairly reliable track record of predicting recessions.

To illustrate the point, the chart below shows the yields of 2-year USTs (orange) and 10-year USTs (blue) in addition to the differential between the two (10-year yield minus 2-year yield) in white. While the blue line has remained relatively stable in 2017, the orange line has been moving higher (especially since September). The result is that yield differential (the white line) has declined from approximately 1.3% at the start of the year to less than 0.6% today.


Sources: Bloomberg and Covenant Investment Research

So…. while the yield curve is demonstrably flattening, it is too early to call the end of the economic expansion and get overly defensive in your portfolio allocation for several reasons:

· A flattening yield curve is normal in the expansion phase of an economic cycle when the Fed is raising interest rates. The Federal Funds Rate directly impacts the front end of the curve, hence Fed rate hikes move short-dated bond maturities higher.

· The yield curve is not yet inverted. The differential between the yield on the 2-year UST and 10-year UST is still nearly 0.6%. In the last two recessions, the differential was at this same level five years before the recession in 2001 and nearly three years before the start of the 2008 recession.

· Even when the yield curve inverts, it is typically only a very early signal of slowing economic growth.

The bottom line is that it is worth keeping an eye on the slope of the yield curve, but as a standalone signal it is not currently indicating imminent trouble in the economy.

Consumption Warning – For those who have taken a basic economics course, the following formula should be at least vaguely familiar: C + I + G + (X-M) = GDP. In long-hand, Consumption + Private Fixed Investment + Government Expenditures + (the difference between exports and imports) = Gross Domestic Product. It’s a fairly straightforward calculation, but the “C” is what really matters at it makes up approximately 70% of total GDP. Hence, we pay a lot of attention to trends impacting Mr. and Mrs. Consumer as a road sign in forecasting future GDP growth. As our resident economist (and the brains behind Foleynomics) likes to say, if you get the consumer right, you’ll at least be in the right zip code for forecasting GDP growth. As I’ve written about over the last several quarters, the aggregate consumer is increasingly spending beyond his means, resulting in a lower savings rate and increased debt levels. This is an unsustainable dynamic as neither savings accounts nor the availability of credit are infinite. Eventually consumers will have to consume less, even if today their confidence is high. As the following chart shows, savings rates typically mean-revert over time resulting in lower consumer spending.


Sources: Dimitri Delis, Piper Jaffray & Co

Moreover, future consumption is being pulled forward not only by a reduction in savings, but also by increased borrowing.


Source: The Daily Shot

Ultimately consumers will feel the pinch and reduce consumption levels to rebuild savings accounts and payoff loans (rising interest rates will not help). Like the flattening yield curve, this is another very early indicator that we are in the latter stage of this business cycle. That being said, outside of an exogenous event negatively impacting the economy or a monetary policy error (i.e. tightening too fast), the “latter stage” of a business cycle can last for a couple of years. Nevertheless, it’s a good idea to keep a close eye on Mr. and Mrs. Consumer.

Be well,


13 is not an unlucky number for this bull market as November marked the thirteenth consecutive month of gains for the S&P 500 (inclusive of dividends). This streak is not unprecedented (since 1871 there have been six occasions where total returns were positive in 12 or more months according to Bloomberg), it’s just unusual. In case you were wondering, the longest streak was 15 positive months from March 1958 until May 1959. Time will tell if this bull market has the stamina to challenge the record and reach 16 months (mark your calendar to check back at the end of February 2018). Momentum is certainly on the bull’s side at this point.

Below is a quick summary of monthly and year-to-date performance for a handful of key indices, while more detail on weekly, month-to-date and year-to-date asset class performance can be found if you click here.



Emerging Markets



EAFE (Europe, Australasia, Far East)



MSCI All Country World Index



S&P 500



Barclays Aggregate Bond Index



Source: Bloomberg and Covenant Investment Research


Tax Cuts? – As the Senate and House Republicans push closer to passing tax reform policy, most sell-side analysts expect the plan’s reduction in the corporate tax rate to 20% will provide a boost to corporate earnings. It seems logical that if corporations are currently paying out 35% of pre-tax profits, that a reduction in the rate to 20% would yield higher earnings. It’s just math. But what if corporations aren’t paying taxes at a level anywhere close to 35%? Well, then the “math” gets a little squirrely. The GDP data released last week showed that corporations paid $472.9 billion in taxes over the most recent four quarters through Q3 2017. Dividing this value by the pretax profits over this period of $2,281.4 billion, implies an effective tax rate of 20.7%. Don’t trust the GDP Data (provided by the Bureau of Economic Analysis)? Let’s look at the amount of corporate tax revenue actually collected by our good friends at the IRS over this same timeframe. According to their data, the IRS collected $297.0 billion in corporate taxes, equating to an effective tax rate of 13.0%. As the chart below highlights, the effective tax rate on corporations (the blue line showing taxes paid to the IRS) has been continuously below 20% since the Financial Crisis (source: Yardeni Research).




So… while the common narrative is that a lower corporate tax rate will dramatically increase profits, the reality may be different. At a minimum, there will not be a 1:1 ratio in which each % decline in the corporate tax rate translates into a % increase in profitability, at least not for those companies already experiencing a tax rate significantly lower than 35%. This inconvenient nuance likely won’t prevent stocks from rallying if the tax bill passes, but expectations of materially improved corporate profits in the future based solely on tax reform may be misguided. Having said that, even if expectations of improved corporate profits from tax reform are overdone, one positive effect of lowering the domestic corporate tax rate is that U.S. corporations will have less incentive to expand overseas. This, in turn, will increase job creation (and tax revenue for the government) at home. And that’s not a bad outcome at all.


Millennials’ White Picket Fences – Millennials are the first generation raised in an entirely digital world, which has shaped their identities as well as their political, social and cultural attitudes. With a population of 88 million, Millennials have surpassed Baby Boomers as the nation’s largest living generation and their spending habits will have a dramatic impact on the economy. One aspect of Millennials that has been noted is their apparent indifference to purchasing a home (aka living the “American Dream”) as evidenced by the relatively low cumulative homeownership level of 20-34 year olds compared to prior generations. Yet, research published last week which offers a more granular analysis of the data, including the rate of change in homeownership (as opposed to cumulative home ownership) flies in the face of conventional wisdom about Millennials. This research, which tracked the buying patterns of discrete groups of Millennials grouped by age as they got older, reveals that Millennial homeownership is accelerating. For example, in the chart below the green oval highlights homeownership growth for the two year period in which those 28-29 years old aged to 30-31 in 2012-2014 and 2014-2016. The red oval shows the same age cohorts, but for the time periods of 2008-2010 and 2010-2012.



If you consider, based on their respective ages, that 28-29 and 30-31 year-olds were experiencing the worst of the Financial Crisis in 2008 – 2012, it should not be surprising they purchased fewer homes. The bottom line is that it does not appear that Millennials are so different than previous generations when it comes to their desire for homeownership. Rather, it seems that the the Financial Crisis prevented the Millennials from being able to purchase homes, whether it was fear of the real estate market or being able to get a loan. If that is indeed the case, increased home purchases by the massive Millennial generation will bolster the housing industry, an important linchpin of the domestic economy.


Trader Humor – Low volatility has become a hallmark of financial markets over the last two years and something lamented by Wall Street traders (for whom volatility equates to opportunity). Hence, the sudden, but short-lived, 1.6% decline in the S&P that began just after 11am on Friday morning generated some “gallows humor” that was making the rounds on Wall Street that afternoon.



Be well,