AWM Market Update

Volatility is never a fun experience. There's an old saying that bull markets go up like escalators and correct like elevators. However, that’s the necessary price of admission to achieving long term stock market gains. When younger investors look at the long term stock market averages that have beaten every other major asset class (e.g. cash, bonds, real estate, commodities, etc.) over 100+ years, they often ask “Why doesn’t everyone just invest everything in stocks?” The answer is volatility. Enough investors allow themselves to get “washed out” of the market during volatile times which sends prices down until the expected future returns of the market become attractive enough to draw a new wave of investors back in and the cycle begins anew.

Speed Read

  • Staying calm and remaining rational about your long term investment goals is the single best thing you can do in a market pullback.
  • The S&P 500 has given back January’s gains, but that’s about it.
  • January’s pre-pullback growth was unsustainable. At one point last month stocks were on pace to go up 150% in 2018, 3x more than the best year ever.
  • Although it’s always hard to pinpoint exactly what caused a sell-off, it would appear that the volatility of the last week has been caused by fears of too much economic growth, rather than too little. A strong jobs report last week gave the green light to the Federal Reserve to embark on a series of interest rate hikes to normalize monetary policy.
  • Higher interest rates are generally bad for financial assets, at least in the short term.
  • Markets are inherently volatile and this pullback is a stark reminder of that fact. The lack of volatility investors have become accustomed to in the last 18 months is the exception, not the rule.
  • Corrections of 10% or more have occurred more often than not in the last 40 years, but even in years with corrections the markets finished positive the majority of the time.

Long Read

It’s been a whirlwind week in the stock and bond markets. Following last week’s stock market declines, stocks fell further yesterday. While stabilizing so far today, this is the first real volatility we’ve seen in markets since the beginning of 2016, when fears over falling oil prices sent stocks into a correction. Then, like now, we didn’t think it was the beginning of a bear market for a variety of reasons. 

The sell-off of the last few days is most likely due to strong employment and economic growth while previous sell-offs in this long-running bull market have been based on fears of too little growth. 

Isn’t a growing economy and lower unemployment a good thing? It certainly is (especially if you were one of those recently-unemployed people). But the market and the economy are two different things and what is good for one is not always good for the other. A prime example of this is the most recent jobs report which showed 200,000 jobs being added to the economy and average hourly earnings for private-sector workers rising 2.9% from a year ago. It’s not the additional jobs that are spooking the markets; we’ve added well over 100,000 jobs a month on average for the last few years. It’s the pickup in wages that’s moving markets. So far in this decade-long recovery, the average Joe hasn’t had a meaningfully bigger take-home paycheck even though almost every other economic indicator has improved.

Again, why is the common man having a few more bucks in his pocket a bad thing for the stock market? Won’t they spend more money if they make more money? Probably. All else being equal, that would be good for the economy and markets. However, inflation (which has been hibernating for a few years between 0-2%) is historically driven by wage gains. Why? When you can’t find a qualified person to fill a job opening because everyone who wants to work already has a job, what choice are you left with? Offer more pay to lure potential employees. When everyone collectively does this, that’s typically when you see inflation start to kick up a notch.

If inflation starts creeping higher, that tells the Federal Reserve it’s time to raise interest rates to keep the economy (and asset prices) from overheating. The Fed didn’t raise rates quickly enough leading into the bubble and the housing crisis and fears making the same mistake a third time in a row. The Federal Reserve has kept interest rates extremely low since the Great Recession to stimulate economic growth and to push investors into riskier assets. We started calling this phenomenon the “musical chairs of markets” a few years ago. If you were a CD buyer before the financial crisis, you might have been forced to buy bonds in search of a higher return. If you were traditionally a bond buyer, you might have purchased Procter & Gamble and Philip Morris stock for the strong dividends which were higher than bond yields at the time. In short, low interest rates encourage risk taking, reward debtors and punish savers. 

Why do low rates increase risk taking? If you’ve ever thought about buying a rental property, you would be more likely to buy it if you could borrow at 3% interest than at 10%. Obviously a lower interest rate is more attractive and may even increase the amount you’d be willing to pay for the property. This phenomenon happens in stocks, bonds, real estate, farmland, etc. Any income-producing asset is worth more if interest rates are low and progressively less as rates climb. If interest rates climb slowly and steadily, we think the markets can absorb the higher borrowing costs. If they rise much more quickly than previously anticipated (which seems to have been the sentiment from the past few days), there could be more volatility ahead.

Overall, we believe maintaining a balanced investment approach and not reacting too emotionally to swings in the market continues to be the best path forward for positive long term returns.

As always, we thank you for the privilege of serving as your fee-only registered investment advisory firm.

Best regards,
Your Arbor Wealth Family

Looking at the 2017 Autumn

Speed Read

  • U.S. stock markets have performed well, but valuations are increasingly stretched.
  • High stock valuations are supported by possible tax reform and the notion that interest rates will remain low for a long period of time. If interest rates continue to rise or tax reform fails, U.S. stocks could stumble.
  • Rising interest rates along with decreasing levels of central bank support from the Federal Reserve, European Central Bank and the Bank of Japan will likely lower broader market liquidity levels for the remainder of 2017 and into 2018.
  • Central banks are now publicly asking themselves whether they’re more concerned with high asset prices or low inflation levels. How the Federal Reserve and the ECB answer that question via the speed and severity of interest rates hikes and tightening financial conditions will likely drive near-term market performance.
  • Staying invested, given the paltry alternatives, is vital. However, a cautious outlook and positioning is warranted given premium valuations and potential near-term road bumps.

Increasing Risk Appetites

“Be fearful when others are greedy and greedy when others are fearful.” - Warren Buffett
As you know, we have experienced almost nine years of relatively uninterrupted growth in the U.S. stock market (and the 3rd longest business cycle expansion on record). We believe many investors are taking on increasingly more portfolio risk at a point in the business cycle when history and prudence would suggest that the opposite course of action, temporarily reducing risk levels, is the best path to achieving positive long-term returns.
The increasing risk appetite amongst the investing public can be viewed a number of different ways, but a basket of simple metrics show that investors are unequivocally more excited about future investment returns than they were even a year ago.
Wells Fargo/Gallup’s most recent U.S. Investor and Retirement Optimism index is at levels not seen since the roaring bubble. Household stock exposure is close to 2008 levels, again only surpassed by the market peak in 2000. In fact, more than half of all U.S. household financial assets are now invested in the markets, up from a ~30% historical average. Cash allocations are at era lows. The Investor Intelligence sentiment index (also known as the Bulls-to-Bears ratio) is at a post-1987 high. Personal savings rates, which surged upward for a brief period following the financial crisis, have drifted back to pre-crisis levels.
Consumer confidence, which recently reached December 2000 levels, is another curious statistic that one would think should be a positive for markets. It’s consumers who drive the economy and if they’re optimistic they’re likely to spend more, right? But there’s a lot of data that supports the notion that consumer confidence is actually a lagging indicator because it’s typically after folks buy their big ticket items that they report confidence about the future. After all, the reason they made a purchase decision on a car or new washing machine was because they felt confident about the future in the first place.
So eclipsing the December 2000 consumer confidence levels sounds great on the surface, but when you recall the fact that the meltdown and bear market that lasted two years had actually already started a few months earlier in October of 2000, it signals that investor caution is warranted.
No matter how you slice it, investors are optimistic and think the good times will keep rolling. In isolation, any of these statistics would be considered with a grain of salt. But together they paint a picture of general optimism which is likely priced into markets to a large degree. Unfortunately, investors tend to be most optimistic about stocks after they’ve done well (and future returns are likely lower than in the recent past) and become pessimistic only after they fall (when there’s actually less risk and future returns are likely higher). 
In short, investors are growing more concerned with the return on their capital than the return of their capital. 
We believe that staying cautiously positioned in the near future will give us the ability to capture greater prospective returns should volatility pick up. 

Buying Into Market Hype

To illustrate just how easy it is to get sucked into the buy-at-any-price mentality, let’s look at comments made by Mad Money host and former hedge fund manager Jim Cramer.
Almost a decade ago to the day, on Halloween of 2007, in the 5th year of a bull market Cramer said “You should be buying things and accept that they are overvalued, but accept that they're going to keep going higher. I know that sounds irresponsible, but that's how you make the money. Right now, up is down, left is right, peace is war."
That’s how many investors feel today; most professional investors will freely admit the stock market is expensive, but those same managers believe they simply have to be invested out of fear of missing out on the next uptick. But it’s when we all collectively “buy in” and believe that stocks will always outperform everything all the time that things tend to go off the rails. When Cramer made his buy-at-any-cost comment, it reflected the sentiment of the time. Unfortunately the U.S. stock market had already peaked a few weeks before his statement en route to losing 54% of its value in the next 17 months. What had worked leading into his Halloween call, buying overvalued stocks and watching them go up, stopped working almost overnight.
We don’t mean to pick on Cramer. He seems like a generous, kind-hearted individual and has been a great financial communicator to the masses. But these market musings that encouraged folks to buy overvalued companies simply because they may go up a bit further at the top of a market cycle point out a glaringly obvious investment truth: the more you pay for an asset, no matter how great it is, the lower return you receive. A great company can be a risky investment if purchased at too high a price. Conversely, a middling company may be a wonderful investment if purchased at a bargain price.
Instead of losing half their life savings in less than a year and a half, clients who were with us from 2007-2009 will remember seeing very stable portfolio values. We saw heady optimism bubbling up and became more defensive in order to protect capital. We didn’t call the downturn on a dime, but we feared losing our clients’ hard-earned life savings far more than missing out on the last uptick in the stock market. While we don’t see the same level of excesses in markets today that the housing market displayed in the months leading into 2008, we do see the same “buying X always works” mentality. Back then, it was houses. Today, it’s large cap U.S. stocks.
From an emotional or psychological perspective, becoming more conservative and stepping back on risk taking is hard to do when the recent trend in prices has been up and taking ever more risk has been rewarding. It’s like leaving a party in full swing at 10 o’clock at night: if the party rages on you may miss the crescendo of the night, but the next morning you’re almost certainly more likely to feel better than those that fully participated in revelry of the night before.

Rising Interest Rates vs. Stock Markets

Perhaps the single most important consideration to investors today, especially when viewed in the context of high stock valuations, is an increasingly aggressive Federal Reserve. Jerome Powell has been nominated for Fed Chairman but, if confirmed, he is largely expected to continue Janet Yellen’s policy style. Even accounting for a potential replacement of the Fed Chair, a December interest rate hike is viewed as an 92% probability by the markets. If the Federal Reserve hikes rates in December and continues hiking in 2018, stock investors should take note. When the Federal Reserve starts hiking rates, they rarely stop until the economy hits a recession. In fact, 11 of the last 13 recessions have been caused by Fed tightening cycles just like the one we’re currently in. 
In the 101st month of the economic expansion the Federal Reserve is increasingly antsy to return the economy to “normal”. This means higher interest rates over time. The only factor that has kept them from moving interest rates successively higher has been persistently low inflation. Now that inflation seems to be nudging upwards (even though it’s still very low), the Fed has the green light to raise interest rates.
In addition to the Fed charting a course for higher rates in the coming years, other central banks around the world are now repeatedly and very publicly questioning whether fighting low inflation is more important than popping asset bubbles before they grow too large. If they come to view ebullient stock markets as a bigger economic risk than low inflation, they may ramp up the pace of financial tightening. To this effect, the European Central Bank, led by Mario Draghi, recently signalled their intentions to slowly pull the punch bowl away from markets.

Moving Forward

In summary, we remain optimistic on the U.S. and global economy but believe caution is warranted in portfolio positioning given the extreme optimism priced into markets and rising interest rates. Furthermore, we believe the asset allocation and security selection decisions made on behalf of our clients will weather downturns particularly well and we continue to prioritize downside protection when making new investment decisions.

Best regards,
Patrick R. McDowell, CFP®, AIF®

How A Trump Victory Might Impact Your Portfolio

After a long election season, Donald Trump has won the presidency and the Republican Party now controls both the House and Senate. What does it mean for everyone’s portfolio? Although it is still very early, here a few of our thoughts on the potential impact to the investment landscape:

Most segments of the healthcare industry – specifically pharmaceutical manufacturers (drug companies), pharmaceutical distributors and pharmacy benefits managers (PBMs) – will likely benefit from a Trump victory and early trading seems to confirm that. Secretary Clinton made clear in her campaign that she wanted to rein in drug pricing and reform different aspects of the pharmaceutical distribution industry. These businesses are where most of our client’s healthcare investments lie and are now unlikely to change dramatically due to regulation. Health insurers, of whom we own very little, are likely to suffer with any potential repeal or rollback of the Affordable Care Act.

Financial companies like banks, insurers and payments processors are also likely beneficiaries of a Trump victory. Under semi-continuous scrutiny since the financial crisis, “Wall Street” is unlikely to be punished as they might have under a Clinton presidency. For example, former Wells Fargo CEO John Stumpf’s recent Senate Banking Committee hearing revealed many lawmakers’ desire to further rein in the banking industry. The balance of power has now likely shifted away from that perspective which is a positive for investors in that sector.

On the fixed income side of the equation, a potential outcome of the Trump presidency is that long-term interest rates might rise more quickly than previously expected, which would hurt long term bonds (of which we own very, very little). Long term interest rates, like the rate you pay on a 30-year mortgage or receive on a long-dated Treasury bond, are heavily impacted by inflation expectations. After all, if you loan someone money for a few decades, you want to be sure the money they repay you with is still valuable by the time you receive it. Why the potential uptick in inflation? Infrastructure projects funded with fiscal stimulus, which has been a hallmark of the Trump campaign, is typically funded by government borrowing. When governments increase their borrowing they often have an incentive to inflate their currency to pay borrowers back with cheaper dollars over time. But inflation, which has been relatively docile in the past few years, will likely take a while to heat up and so there is no immediate cause for concern.

Finally, domestic companies that are large exporters might experience temporary volatility as the market assesses how proposed trade renegotiations might impact their businesses. Our view is that any trade renegotiations, if they occur, will take far longer than many expect. The intricacies and functionality of Brexit (the United Kingdom exiting the European Union), which also recently surprised markets, are still being worked through with no near term end in sight.

These are some of our initial thoughts on how the change in administrations will likely impact investor portfolios. As with the recent Brexit surprise, which shocked the markets but is now old news, we think a measured, even-keeled approach to any market surprise is the best course of action.

Best regards,
Patrick R. McDowell

Spectra Energy Partners Announcement

A few weeks ago an energy distribution and transportation company called Enbridge Incorporated ENB disclosed that they had agreed to acquire Spectra Energy Corporation SE in an all-stock deal.

Why does this matter?

You own shares in Spectra Energy Corporation’s Master Limited Partnership (MLP) subsidiary Spectra Energy Partners SEP. According to the announcement, Spectra Energy Partners will continue on as a publicly traded partnership, so your shares will likely be unaffected by the acquisition. If this is the end of the story, we will happily remain unitholders (shareholders) in Spectra Energy Partners as they will remain, in our view, the best midstream MLP in the country.

One way your shares might be impacted in the future, however, is if Enbridge Incorporated and Spectra Energy Corporation decide to combine, or “roll up”, Spectra Energy Partners with Enbridge Incorporated’s two publicly traded Master Limited Partnerships. If this scenario were to come to fruition, it’s probable we would grudgingly sell or largely reduce your holding in Spectra Energy Partners as any combination would dilute their premium asset base and financial position. All in all, this type of transaction would be hugely beneficial for Enbridge’s MLP’s as they would effectively be “marrying into” Spectra Energy Partners’ choice positioning in the Marcellus Shale, which is the country’s most plentiful shale formation. 

 Spectra Energy Partners at a Glance

The premium positioning of Spectra Energy Partners’ assets is only one aspect of what makes the partnership such an attractive investment. Spectra Energy Partners, which essentially owns and operates long-haul natural gas and crude oil pipelines, is a very steady, cash generative, “toll booth” business that is currently yielding around 6% per year. In fact, Spectra Energy Partners has no underlying commodity price exposure whatsoever, meaning that natural gas or oil prices don’t affect earnings. Customers reserve pipeline space in advance using long-term contracts and pay fees to Spectra Energy Partners regardless of the volume of natural gas or crude oil that flows through their lines. Additionally, in many of the areas where Spectra Energy Partners operate, they’re the only game in town, meaning they’ve been granted essential monopoly rights on pipeline energy transport in that area. The crown jewel of the partnership is the Texas Eastern pipeline which flows from the Gulf Coast to New York. This pipeline is capable of moving up to 10% of United States gas consumption and connects most of the east coast to the Marcellus Shale. For your convenience we’ve included a slide from a recent investor relations presentation which highlights the partnership’s assets.

We will continue to monitor the transaction and let you know if any events occur which will impact our investment.

Best regards,
Patrick R. McDowell, CFP®, AIF®

The Short Happy Life of Negative Interest Rates

Live for today and don’t worry about tomorrow…
-“Live For Today” by The Grass Roots

With the domestic stock markets close to their recent all-time highs as of this writing, I thought it might be appropriate to turn some attention towards the ultra-low interest rates that have persisted for the past few years.

The title of this Global Glimpse is borrowed from one of my favorite Ernest Hemingway stories, The Short Happy Life of Francis Macomber. I’m not nearly as well read in the classics as I would like to be, but Hemingway has always piqued my interest. The irony of the title is that Francis Macomber wasn’t really a happy man until moments before his accidental death. Hunting on a safari in Africa with his wife, he cowered when a lion charged him. Humiliated in front of and by his wife, he finally found the courage and happiness he so desperately desired the next day as he chased down a wounded buffalo only to be accidentally shot and killed by his wife. So the medicine that was supposed to cure him, facing his fears, ironically ended up killing him. What’s the connection to investing? Negative interest rates, thought by central banks to be the cure for ailing, developed economies, seem to be the medicine that’s worse than the sickness.

It might be a bit early to call for the death of negative interest rates globally. After all, bonds with negative yields being issued today by countries like Germany, Japan, France and Sweden won’t mature for years, so they won’t disappear entirely from the investment landscape. But after watching Federal Reserve Chairwoman Janet Yellen’s testimony to Congress recently we now think it is fairly safe to say the United States won’t follow much of the developed world down that particular rabbit hole. This isn’t to say our monetary and fiscal policies in the coming years won’t be unusual by historical standards, but we believe central banks are increasingly waking up to the realities of what their policies are inflicting.

Academics originally proposed negative interest rates (meaning you pay the bank to hold your money as opposed to receiving interest payments as a reward for your deposit) as a hypothetical response to a potential high debt, low growth world — the situation we currently find ourselves in. Imagining an economy with so much debt that consumers didn’t want to borrow any more even if interest rates were so low that money was effectively free, they argued that punishing savers by denying them reasonable interest would encourage people to spend today and invest idle cash, thereby stimulating economic growth. This theory is the backbone of many central bank policies today.

In reality, the opposite has occurred. The inability to receive any truly safe income (bank deposit interest, treasury yields, etc.) on capital hasn’t induced people to “live for today” as The Grass Roots encouraged fellow youngsters to do back in the 1960’s. Instead, it’s forced the average pre-retiree to look at his or her nest egg and conclude the amount they need to save in order to draw safe interest income in retirement is significantly higher than they had previously projected under more “normal,” pre-2008 interest rate conditions. I guess “Sha-la-la-la-la-la plan for tomorrow” doesn’t quite have the same ring to it. In fact, in countries where the deposit rate has gone negative like Denmark, Sweden and Switzerland, the gross savings rate has actually increased. To put this in perspective, in countries where money is the cheapest (i.e. interest rates are the lowest), consumers still don’t want to borrow money and instead have strongly increased the amount they save relative to their discretionary spending. Admittedly, it will take a number of months and years to truly judge the efficacy of today’s negative rate policies, but increased consumer savings and decreased discretionary spending isn’t typically a recipe for economic growth in the near and medium term.

Another enticing theoretical side effect of negative interest rates was inflation (which the Fed has been trying to achieve for years). Economists view inflation like Goldilocks viewed porridge temperatures. Too little inflation (the current situation) is anti-growth while too much inflation devalues the currency and causes uncertainty which derails investment. Again, theoretical and real-world outcomes are at loggerheads. As interest rates in developed countries have gone to zero and then below zero into negative territory, inflation has actually followed interest rates downward, exactly the opposite of what academics expected. In Japan, the epicenter of the negative rate phenomenon, inflation hasn’t really budged. What has gone up instead are the sales of steel fireproof safes, which have skyrocketed. It looks like consumers in Japan are voting with their feet and preparing to hold cash rather than pay a bank to do the same should rates fall further. So even in Japan, which is led by the Bank of Japan, the wacky cousin in the family of developed-world central banks, it looks like negative rates are starting to reach their limitations.

What does that mean for US investors? A few things.

For one, as mentioned above, it appears increasingly clear to us at Arbor Wealth that the fad of negative interest rates being aggressively pursued by more “experimental” central banks than our own Fed appears to be losing admirers. The benefits of negative rates, if there ever were any, appear to have been fleeting. And now they actually seem to be hurting many economies more than they’re helping. Negative interest rates simply scared more people into hoarding money than it “nudged” others to spend tomorrow’s income today. In our view, the Fed sees this as well and has decided to “not go there” as kids say. Whereas implementing negative rates here at home was a serious topic of discussion among economic elites even a few months ago, the tone of the discussion has shifted significantly as other economies have served as real-time test cases and the results don’t look promising.

In our view, the Federal Reserve’s lack of desire to go into negative territory also relieves quite a bit of anxiety for domestic investors. The US and the US Dollar have, since the end of WWII, been historically seen as the country and currency of last resort. The good old greenback still settles a huge amount of transactions around the globe. The fact that the Federal Reserve is indicating that they have no desire to change the historical understanding of the value of money (I deposit money in your bank and you pay me interest) is welcome relief to many investors. By simply saying, “we’re not considering that possibility” the Fed has given a huge amount of clarity to the financial markets.

In an obviously strange financial world, this new piece of relative certainty is welcome news. While global interest rates will likely remain very low by historical standards for the foreseeable future, we don’t believe investors will accept negative interest rates much lower than what we’ve already seen.

Best regards,
Patrick R. McDowell, CFP®, AIF®