Michael Carlin
This is Michael Carlin, President of Henry+Horne Wealth Management and we are here with your 4th quarter, quarterly market outlook. As always, we are going to be doing this one slide at a time trying to go through the data to find out what’s real what’s not real and where we’re going.
Today’s my birthday and in the spirit of celebrating things, we are celebrating this year’s closure. This is going to be the last of the 2018 market outlooks. This is going to be the year for us, it’s exciting!
Steffan Dye
The fourth of the series of four. I think we’ve improved as we’ve gone along. Our technology is getting better!
Michael Carlin
Slides are still awesome and this quarter we got a lot of good data!
Steffan Dye
We’ve got terrific data. For those of you reading, you would be amazed at the research teams that we have behind us.
Michael Carlin
Let’s go through it. You see, one of the things that we saw early was a cover of Fortune magazine and a cover of Barrens. Those two covers stand out to us because on the cover of Fortune magazine you see a guy screaming wearing a sign “The End is Near” in a business suit. In the Barren’s article. “The Bulls Final Countdown” with a raw piece of steak on the cover. Both articles are saying the same thing. Don’t get too excited about the market cause it’s over. What we see is that fear is becoming more palpable for the first time in a long time. As of right now, in October, as we’re looking to close out the year.
Steffan Dye
The media needs to sell magazines and commercials to get your attention. I think the Barrens piece of beef you’re talking about says, “Best diffused by 2020.” We had a client in the office last week who said he felt like the bull market was going to continue until 2019 or 2020. The media encourages specific dates as if they know what’s happening in the future. We don’t know what is going to happen in the future.
Michael Carlin
I would encourage you to google the Death of Equities article. You are going to see that throughout history and decade after decade, Fortune money magazine and others are all predicting the end of the market to indicate how are we going to get people to buy our magazine. If you look at the real market results in coordination to magazine covers, they are almost opposite. So, don’t take your advice from the cover of a magazine. The market we are in right now may be the least loved bull market of all time.
Let’s peel back some of the data. Where is money going? If you look at mutual funds and index funds for US stocks, it’s shocking. There has been a flight towards passive index funds and a flight out of actively managed mutual funds virtually every year since 2009. We are trying to figure out again, where does the money go? We are seeing passive is pulling in a fair amount of domestic dollars, but the inflows are not overwhelmingly high. If you’re looking to see where some of that money is going, it stands out. We will talk more about this. The money is flowing into bonds and bond funds.
Steffan Dye
You are seeing it move out of domestic mutual funds and into domestic ETF’s. The flows out of mutual funds is far greater than into the equity ETF’s. The real funds the flows are moving into the bond funds. You are also seeing movement into mutual funds and ETF’s for international equities.
Michael Carlin
Interesting how they both active impassive international attracting money.
Steffan Dye
Attracting money and has been since 2009 even though you’ve seen some underperformance a lot of that period. There was some out performance 2017 but, 2016 and 2015 you saw under performance and this year you’ve seen dramatic underperformance again even though the money continues to move international.
Michael Carlin
Another inference not to draw if you’re an investor and don’t look at the cover of magazines to see if money is going into the US market or international to determine where you should be putting your money. You need a lot of data points to look at so let’s go ahead and dive in. Remember all that money piling into bond funds was done before rates appreciably went up. Meaning, all that money flowing in there has likely lost a significant amount of value. Following the dollars does not always give you the best indication of where to put your money moving forward.
Steffan Dye
The global financial crisis affected a lot of people dramatically. People tend to look through the rearview mirror when they are trying to anticipate what the markets are going to do. As this bull market and stocks continue to run, a lot of people are still worried about what happened in the financial crisis and still see that in the rearview mirror.
Michael Carlin
We hear it all the time with our clients. We are looking at the duration of the market and it’s stunning. This is the longest bull market run in history where stock prices reached valuations that no one considered. It’s interesting if you look at the total length we’ve matched it. But, if you look at how much the market has appreciated, the only bull market run that’s been better has been that .com bubble bursting and it’s hard for me as an advisor to imagine us getting back to those outlandish valuations that did not make sense.
I remember as an advisor in the late 90’s there were endless stories that I was reading from different publications like Merrill Lynch or Morgan Stanley that were saying, “this time is different.” You could buy Microsoft and Cisco at any price because you could look at what’s happening with the economy and the way the world is going. The prices made sense because here’s how much money they are making in the future and it all seemed for a moment rational until you look back and see how irrational it really was. It starts to feel that it doesn’t matter what Amazon does. It’s the future of this, it’s happening with there. I start to feel that sense of irrationality. I’m not trying to compare Amazon to some of the other .com stocks, but I am saying the stories are feeling similar.
Steffan Dye
You hear people trying to justify very high valuations with stories that may or may not be right, may or may not make sense. Just for grounding that 1990-2000 bull market ran for 10 years and it ran up on the order of 425%. That was a heck of a bull market. The average bull market that we’ve seen since 1928 has been 57 months, so about half of the 120 months longest, and its ran up 165%. That’s a pretty good run. This one now is over 120 months and is on order 330-340%. So, it’s the longest one and the second highest and second strongest move.
Michael Carlin
I don’t think we have a problem with it going up because the market went down a lot before. There has be to an extra atonement and there has to be an extra push higher, but it’s starting to get to a degree where we’re going to continue to look through the data and when is enough? The market made a new high since our last call, which is exciting and interesting.
Historically, when the market makes a new high, 8 months after making its old new high, it’s historically a bullish sign of the market moving higher. If you look at it as soon as you reach that new high, historically speaking, it issues another 10% run on top of the market move that you just saw and that creates a little bit of confusion because I want valuation length and duration but we just made this new high and historically speaking it’s a good sign of things to come.
Steffan Dye
Well it is and sort of boring finance stuff there what they call beta which is the market return and then there are anomalies where you get out performance relative to the market return. The two biggest ones are value, which means you but stuff cheap, and then momentum, which is the strange experience where things that are trending upward have a tendency to continue trending upwards whether it’s an individual stock or a stock market. We see these 52 week highs after an 8 month period without one. More often than not, you’re going to be higher than before.
Michael Carlin
So, don’t sell your stock quite yet. The question starts to be, can we run higher? And we’re seeing some signs where if you compare this market run to the last 4 market runs before, we had a significant sell off the way this market is trading reaching higher highs you see a little bit of and market down turns it’s eerily similar to some other markets. One 2010, 2011, 2012 and 2015 where we got 10% plus corrections. We are going to see some similarities which would be indicative of some type maybe in the month of November we might see the market pull back temporarily.
We have this conflicting report and we have some data of a market high, market moving 10. We have other data suggesting at this point a month and a half away from the market reaching its crescendo and maybe we do go up another percentage point between now and then. It’s interesting as you go through it and I think what you’ll find listeners as you hear us go through it, we are going to help you draw definitive conclusions as we introduce all of this data.
Steffan Dye
There is a lot of mixed signals, but we want to provide clear guidance. I was doing a talk 2 weeks ago. In the beginning of the talk someone in the audience said, are you going to scare me or excite me? I said, well I’m going to show you some interesting things on both sides you’ll tell me more about your pre-disposition to what I say then what I’m going to say.
Michael Carlin
Peoples’ pre-disposition does matter in terms of how you allocate portfolios. One of the things I’d like to point out is the federal reserve or real fed funds rate again, fed fund rate is the short term borrowing rate that has for a long time when the fed borrowing rate was at zero and you had inflation on top of it the real rate was less than zero. Now we are 2% and the fed funds rate inflation depending on the particular quarter we’re going to round that number. We are going to see where there is a positive real fed funds rate somewhere between 0 to 2%.
Historically speaking, since 1960 the market rate of return has been 4.3% when you have a real fed funds rate between 0 and 2% then we know because the feds have to increase likely in December perhaps another couple of times in 2019 their going to increase rates on the short side it should be higher than our inflation rate which puts us squarely in this bucket which is 0 to 2 number you see a 4.3% average rate of return in compared to having a real inflation rate real fed funds rate of 2-4% or less than 0 your market rate of return is less than half of what you expect at 4.3% which is challenging. To me, it feels like the kind of data where it starts to make sense. Couple that with how far the markets run the magnitude with which it is run and the fact that we’re in this period where the feds raising rates and we have to deal with the cost or higher wages, it starts to make sense that it’s going to have an impact on market returns.
The story that I read this morning and the data points indicate we should be seeing more market volatility for the next couple of months, quarters who knows how long. This is what happens when the feds start raising rates and it starts to hurt.
Steffan Dye
There’s the narrative economics everyone knows that when the rates start to rise it can affect equities. On the other hand, had we know that rising rates mean a strong economy and we’re looking ahead and seeing a strong economy but the cost of money is rising.
Michael Carlin
You talk about the economy being strong? We’ve got the same bull market checklist that other firms do. If you want to look at it, we’ll be happy to send it to you. If you look at the data points right now, a lot of them at this moment indicate the bull market should have a little more energy to run forward. If you look at data like how is the consumer doing? If you look at the personal savings rate, I see good numbers there. Looking at consumer confidence I see best figures for confidence. It’s still a consumption-based economy for confident consumers, consumers that spends that’s something that’s going to move us forward. That looks good too.
Steffan Dye
It looks great. We didn’t talk about it before, but ISM survey which is one of the best indicators I’ve ever seen to mirror the business cycle. It’s very high. Typically, when that ISM survey is high the market tends to go up. So, you have confidence and the reason to have confidence is the economy is strong.
Michael Carlin
Two of the things academically we continue to think there is some opportunities there for growth would be small caps and global. A few reasons, one being valuations. We don’t like paying a lot for companies if we don’t have to. Certainly there are other areas we can grab that growth opportunity at a lesser premium. If you look at things like small caps, what’s interesting is that in 2011 and 2015 small cap stock had 2 significant corrections. In 2011 30% in 2015 was a minus 27%. Some say we’ve already had a reset in small caps so, I understand the large caps with chip stocks haven’t gone down and had that reset button like small caps.
When you couple that with better valuations and U.S. first fiscal policy, well maybe there is some fundamentals but high in small cap and maybe even mid cap to the same degree where large cap might be extended.
Steffan Dye
That’s exactly right. Small caps are typically more volatile than large caps, so if you want to take advantage of potential better valuation you’re going to want to be willing to hang on and ride the ride because it can get a little bit bumpy, although it’ll probably outperform over time. You mentioned value, the same thing there. We could find good values. The data shows after a long period of time, value outperforms the market dramatically.
The best value investor Warren Buffet everyone knows him, but you can under perform in value for 10 years. In fact, there was a 10-year window where Buffet himself underperformed the S&P 500 for 7 of 10 years but over the 10-year period he out performed 4% per year. So, the 3 years that he out performed were so dramatic, but you need to ride through it if you’re going to play the game that way.
Michael Carlin
We see that a lot where investors fall in love with their prior returns if they are good or if their prior returns are not great then there’s a disconnect or somethings wrong, but that’s not always how things work. They don’t always routinely stay the same, there is some variability to how you’re going to earn rates in return.
Steffan Dye
My wife says when I talk about financial things, she calls it boring financial stuff. She tunes out and rolls her eyes and goes and does something else. (laughs)
Michael Carlin
Are we dangerously approaching that? (laughs)
Steffan Dye
Well, what I was going to say is some listeners may think this is awful boring financial stuff but there is a term called ergodic which means a cycle will be repeating cycle, cycle, cycle assumption that almost every investor makes without realizing it that every cycle is going to be the same. The truth is, we don’t know whether a 5,10, or 20-year cycle will repeat. We don’t know what’s coming.
Michael Carlin
We try to navigate and read the tea leaves. I mentioned small caps reset twice between 2014 in the middle of it and 2016. Look across the world there were markets, look at Shanghai the Chinese market down just about 50%. The European, their equivalent to the S&P 500 down 27%.
There was also a reset that happened not just to small caps here in the US but also overseas. Again, many think that we talked about the length and duration of this rally, but wait hasn’t there been resets in other places? And the answer is yes, which gives those that have this bullish case for stocks to continue to run some fuel to say no there are other parts of the world that have resets, so we should have more room to run here.
Steffan Dye
You’ve got Greece down now in a draw down on the order of 90 plus percent and Russia in a draw down now at another 60 something percent but you have to wonder is that a value trap, are they going to keep going down or at what point do you jump in? If you look at it as we do, every week a chart of US performance compared to the rest of the world equity performance to emerging market performance, you see a stark dramatic contradiction right now where globally things are going down, the emerging markets going down, but the US is going up. It’s interesting to see the dichotomy.
Michael Carlin
It didn’t use to be that way. It used to be something like if China sneezes then the US catches the cold. There are all kinds of things that you worried about and now with, and will talk more about this later, the Chinese market down significantly, it’s to your point. Part of it is maybe central banks. We’ve got a great chart that lays out all the major central banks across the world. You can get a sense for their total activities. It’s got the Federal Reserve, QE1, QE2 their total balance sheet and you’re also seeing the Federal Reserve for the past certainly year to date the balance sheet is shrinking to the tune of about 100 billion dollars plus per month. You look at Bank of England, Bank of Japan and European Central Bank – those lending institutions continue to expand their balance sheets while we don’t.
Steffan Dye
We’ve talked about this all year long of what’s going on with the central banks. It may be the most important factor in what’s going to come. We don’t know for sure. To simplify, why do we care so much about that when there is more money in the economy chasing the same amount of goods and surfaces in the forms of stocks then the prices for those stock go up? When the central bank started taking money out of the economy, there’s less money chasing those goods and surfaces in the form of stock and that can cause them to go down. So, it’s interesting to see here how the major central banks across the world continue to inflate, continue to add capital, continue to put the punch bowl out whereas the fed keeps taking it away a little bit.
Michael Carlin
In the fed, if you look at these charts, the fed leads the world in this kind of activity. Is it another sign or symbol that maybe the punch bowl will be pulled back not just here in the US but worldwide? What does that mean? What are the impacts we see with interest rates? Let’s talk about the 10-year treasury for a moment. 10- year treasury had a major move here recently. It finally broke through resistance, it’s been struggling to hit 3% and stay about it and it has reached a new mile stone. We are at a 3.15 -3.2 range. It’s interesting because now many expect it to continue to accelerate higher from here.
The 30-year US Treasury also went significantly higher. It made many relax to some degree because we’ve all been so worried about this inverted yield curve. Can the long reigns get higher because we know the short reigns are getting higher? It was exciting too many to say geez the whole yield curve was steepening at that time. I wonder if there is a natural cap in that 10-30 year treasury? What I mean is, if you look at global interest rates and where we are in the US at the 3% plus range in the 10-year look around the world. Germany is 1.3%, UK 1.4%, Japan at .1% and Switzerland is -10 basis points.
Steffan Dye
Negative if you can believe it.
Michael Carlin
You give me your money for 10 years and I’ll give you less. Guaranteed!
Steffan Dye
That’s not even inflation adjusted to a negative. We’ve gotten used to inflation adjusted negatives in different parts of the world even here is the US, but that’s a nominal negative, actual negative.
Michael Carlin
So, it’s hard for me to imagine a world where US rates can continue to serge higher in the worldwide competing for capital. We are still the highest quality market in the world and with the rest of the worldwide rates being so low, you struggle to see how US rates can surge higher from here. There should be enough worldwide demand to keep those rates low.
Steffan Dye
Exactly. You think if the US has a higher interest rate money should pour to that higher rate and as money pours in that should push the price up. The price going up of course would mean that yield coming down so that’s your cap that you’re talking about.
Michael Carlin
Factor that in where you’re looking at federal funds rate, whether we can sustain it, and whether or not the feds are going to tighten until something breaks. The charts show will the fed tighten until something breaks. If you look going back to 1960, if you’re looking at leading economic indicators all bundled together on the same chart. We have hit such historical highs on this leading economic indicator chart where it seems stratospheric it seems that way. So, what many of the listeners should already know, and if you don’t you should, the Federal interest rates will lead to things slowing down. It will lead to the economic activity slowing down. It does lead into market confusion ultimately to market correction.
The question is, when? If you look at the leading economic indicators as a data point, you say wow, this is super extended. It’s unbelievable.
Steffan Dye
You see from 1960 continued growth. Continued growth you see a big move in the leading indicators before the recession before the red market in 2008 and since then a strong powerful direct move that continues to push forward. The leading indicators are called indicators for a reason. They do a pretty good job of telling you what’s coming.
Michael Carlin
So, the market expects continued expansion, and in the face of continued expansion come tariff. We’ve mentioned tariffs likely every quarter this year. Every time Trump announces a new tariff the market goes down that same day. It’s interesting though, that since the tariffs were announced our markets appreciate higher. Since tariffs have been announce in China, China’s market is down 25% roughly over that same time period. Clearly not able to brush it off the same way as our market is.
I think to myself, I wonder what Trump would do if the tariff talk took down our market 25%. I’m sure it would seem likely to me that Trump would say, if the market drops that much I’m going to change course, but he’s able to be so emboldened and passionate about tariffs because we haven’t paid the price here the way they have in China.
Steffan Dye
When you think to yourself, who is winning the trade war, and you use the barometer as the winner of the trade war, the stock market in China and the United States, then we are clearly winning the trade war. We will see what happens. I don’t know if it’s the 1st quarter or the half time or 3rd quarter of the war and I’m not going to say who wins the game till it’s over, but right now our market is dramatically outperforming.
Michael Carlin
For the sake of our clients, thank goodness. Again, I want to touch on the yield curve, we’ve mentioned it many times. You will notice when you look at the data we were so close to being zero until this most recent surge higher. So, you may see the data reverse itself a little bit where we didn’t quite hit zero. We need to keep watching it to see if indeed the yield curve is going invert or get to zero. By the way, every time the yield curve has gotten to zero, it’s always gone negative. We are watching the data and it’s improved a bit. Maybe we’ll escape the jaws of defeat, I don’t know.
Steffan Dye
I think we’ve talked about this before. I’m fascinated with it and more often than not, the talk about yield curve inversion is a discussion about recession. Recession is important to us as a country, but as investors we care more about bear markets than recessions in the economy and what you’ll see with the yield curve inverts is sometimes the bear market will begin that month. One time in 1978, yield curve inverted bear market started that month and in February 2000 yield curve market revert, bear market started the next month. That’s why we are sensitive to that yield curve version.
Michael Carlin
What are the “Bright Spots?” Think we should do some bright spots? Bright spots it’s money coming back to US soil. The repatriating the foreign dollars. We had trillions of dollars earned overseas. Corporations were not bringing those dollars back for a variety of reasons. One of them being they would have to pay a second tax, one when they earn it and one when they bring it back to the US so, they say no we won’t bring it back. In the tax law reform that was changed you saw repatriated dollars of 7 hundred billion dollars coming back sitting on US corporations and US balance sheets here domestically which would make you wonder what they’re doing with it.
Steffan Dye
What are they doing with it?
Michael Carlin
There are 3 different things that we see. Capital expenditures, business reinvesting in the business equipment and things like that.
Steffan Dye
Investments, you bet.
Michael Carlin
Or maybe share repurchases, buying more shares of their stock to decrease the number of shares which will make the existing shares left outstanding more valuable. It makes the stock price higher some call that financial engineering. Maybe they’re paying a few dividends to the shareholders. If you look at this chart, dividends continue to increase, but we’ve seen this increase sequentially at the same rates that we’ve been seeing in the past. It doesn’t seem to me that our repatriated dollars are going into that because it’s just a continued smooth line. Well, capital expenditures have spiked as well. We love cap expenditures which we will talk a little bit more about if it’s a sign for future potential growth. A lot of transaction activity to reduced share accounts. If you look at where the money is going, it is coming back, and it is favorable for stocks which explains in part of what we’ve been seeing.
Steffan Dye
It also helps explain how we’re compensating for the damage done, potential damage done to the tariffs, because of the tariffs. I know that I see this, and Mike you see this, investors, friends, and businesses are being affect by the tariffs. I hear about it every week somebody or somehow its affecting their business. I think to myself, how is it not affecting the stock market war or why is China hurting more than we are? I think part of it has to do with this money coming back like you’re talking about and it’s getting spent and we are buying back shares which pushes up prices. We are investing the money.
Michael Carlin
Lower taxes and lower corporate taxes help too. So, if you’re looking at capital expenditure plans for publicly traded companies, we’ve seen continued expected increases in capital expenditures. When we have businesses reinvesting in themselves, that is a great thing short, medium and long term. We want them growing and doing things that help make the economy move forward. It’s great for jobs, it’s great for productivity and a whole bunch of economic measures in real measures too. The rate of expected capital expenditures is slowing. It’s improving, but the rate of improvement is slowing. Which is one of the things that we want to be able to hang our hat on is something like this, oh the money is coming, and businesses are going to invest, but we’re seeing the rate of improvement slow. We need to be careful of this. Couple of other things, cash. Cash used to be zero.
Steffan Dye
Still, a lot of people are getting zero on their cash in the checking account, but they don’t have to.
Michael Carlin
By the way, negotiate with the bank. Call your bank, call us, there are 2% available on cash. Some people are putting money into CD’s. We don’t recommend CD’s often, You never know, but there are options out there. What’s changed is that the yield on stocks was greater. Let’s pick the S&P500. The yield on the S&P500 was greater than what you would be getting on safe fixed rate investments. You would have investors in droves making the decision. For example, I’m going to be investing for the next 5 years, I’ll pick Apple. Apple pays a 2% dividend at some point in the future Apple stock will be higher. I’m getting zero on my cash so, I may as well buy Apple and get a 2% yield and hope the stock goes up. Which by the way, it worked out great. So, there’s a lot of S&P500 based dividend paying companies that have that same formula. Dividend is getting this, I’m getting nothing on cash. Now the yield on cash is greater than the yield on the S&P500 which gives people choice.
Steffan Dye
So, now they have a choice. Do we look for the dividend from the S&P or do we take the interest rate off the cash which is a little bit better and at the same time have the opportunity to reduce a little bit of risk. You’re sort of forced into the risk before, but now you don’t have to take risk if you don’t want too. Which could draw some capital away from the stock market. People decide to take some chips off the table and get the same yield as we can get from the S&P500, but not have the risk.
Michael Carlin
Right now, the 2-year treasury yield on this chart is greater than the yield in the S&P500 dividends. It hasn’t been this different, this much higher over the 2-year treasury versus the S&P500 dividend yield since the financial crisis.
Steffan Dye
It’s been a long time.
Michael Carlin
To, me the conclusion is, you have to be expecting significant volatility, because the Feds’ playbook has been very clear. We are going to be raising rates. They want to raise rates for a variety of reasons. One and most importantly they want to have a tool when the economy does start to slow down. The best and easiest tools to cut rates, to help push the economy forward and you can’t cut rates if you’re already at zero. So, you need to have it elevated which is what they are doing. They seem laser focused on it competing with the Fed.
Steffan Dye
The Fed also, part of their mandate has to do with inflation and the most dangerous type of inflation to big business is wage inflation. We are starting to see wages start to rise. For those of you who own businesses, you might be finding it’s harder to find employees. The labor markets are very tight. Unemployment is very low and those are the kind of setups that can lead to wage inflation and the Fed does not want that. So, they are wanting to take away the punch bowl, throw on the brakes, make sure we don’t get runaway wage inflation and like you said, have some room to ease if they need to when the time is right.
Michael Carlin
So, expect volatility because every time you get into a situation like this, the market is more volatile. We are more volatile now than the beginning of October. Expect that moving forward the fundamentals of the economy still as we see here right now are still rather strong. There’s still good capital expenditure for businesses, still good fundamentals and still good balance sheets, so that helps. If you’re worried about the risk in your portfolio and you’re not one of our clients, call us. We are happy to take a look at what you have and asses your risk.
Steffan Dye
You can email us if you want to at www.info@thh-wm.com. Happy Birthday to you Michael. This is my first fall in the Phoenix Metro area.
Michael Carlin
Thanks for listening to Manage the Funds Podcast. Stay tuned. We will be bringing you a new podcast soon. Take care.
