Broker Check

And the Swamp Shall Remain Filleth

| February 21, 2018

I hope that 2018 is treating everyone well so far!  Another year has flown by, which means we have reached that point where our industry feels an inherent need to share their “predictions” about the markets and economy for the coming year.  We will once again comply, but under protest and with the usual disclaimers!  And apologies for the delay in releasing this outlook – more on that later.  In the meantime (to keep it fair), we will assume that our outlook for the year ahead begins on Valentine’s Day and through the rest of the year….

With that, let’s take a look at how we did last time around.  Taken directly from our “2017 Outlook” from last December:

“Scenario 2 (less probable) – Rates once again pull back, Stock and Bond Prices both rise

Likely the result of continued inaction on the part of the Fed – or demand for our yields vs. the rest of the world keeping longer-term rates lower than otherwise expected.  In this case, we would expect stocks to be the main benefactor, while we would project gains for bonds to be minimal.  Passage of pro-growth fiscal policy occurs, and rates staying contained would buy Washington time and flexibility in the process.  We would also expect future inflation concerns to be a heavy part of the narrative during the year.  This is the best case for one’s portfolio for the coming year, but comes with muted return expectations going forward.” 

One can easily come to one of two opinions based on that outlook.  On one hand, we sound like geniuses as the above synopsis is almost exactly what took place in 2017.  OK, rates didn’t exactly “pull back” – but they stayed fairly flat and much of the fixed income world did experience muted gains as described.  And while inflation wasn’t much part of the narrative for most of 2017, it has arguably been the hottest topic of the year so far in 2018.  So we will put a check mark in that column for us as well.

On the other hand, we might seem like complete morons as we did not list that scenario as our most likely outcome for 2017.  Still, based on the accuracy of the content, the fact that it was not our least likely scenario – and recognizing that we are inherently biased – we will go with genius and leave you to make your own assessment.  (By the way, our 2017 Outlook and all other rants can easily be found on our website in the blog section if you would like to review in their entirety) 

So let’s talk about 2017.  Janet Yellen and her band of easy money cronies did raise rates 3 times during the course of the year – taking the Fed Funds rate all the way up to a whopping 1.5%.  In what was to be her final year at the helm, one can’t blame her for not rocking the boat with her friends residing in DC and on  Wall Street.  To be frank, I wouldn’t be risking my legacy trying to unwind this unprecedented mess either….better off leaving that one for the new guy.  So rates muddled along, and by the end of the year the yield of a 10 year US government bond was about 0.15% higher than it was to begin the year.  

This created what is known as a “flattening yield curve” – or for those of us less interested in such things – short term interest rates were rising faster than longer-term rates.  The analysts on CNBC started telling us daily that this flattening curve – or God forbid an inversion of the yield curve – predicted recessions, depressions or quite possibly the end of the world as we know it.  There is one small problem with this analysis.  Mainly, central banks here and around the globe have spent 10 years manipulating interest rates in never-before attempted fashion.  Comparing today with pre-manipulation cycles of the past seems very irresponsible to us – even by Wall Street standards.

Meanwhile, stocks were churning higher through most of the year….and then along came the tax cuts.  Instead of churning, stocks began screaming higher with the realization that fiscal policy would in fact be “pro-growth”.  Of course, I am referring to growth of corporate dividends and stock buybacks – what we like to call “pro-Wall Street”. 

What was promised to be the “big league tax cut for the middle class” turned into the “biggest handout to political donors in history”.  The tax cut went almost entirely to large corporations.  Don’t get me wrong, this is unquestionably good for stocks in the short-term.  I’m just convinced that it will also prove disastrous for our country / economy in the longer-term.  Yes, I know that I am sounding like some crazy combination of Bernie Sanders and Karl Marx here.  Those that know me understand that this couldn’t be farther from the truth.  So just hear me out…..

I’m going to maintain that at some point in the 80s, the “instant gratification” generation took full hold of our country.  It may have been before then - and I am too young to remember – but I think that is a pretty accurate Ground Zero.  Executive compensation was increasingly tied to short-term stock performance, and compensation packages for executives exploded accordingly.  Corporations began ignoring long-term strategic planning in favor of focusing exclusively on next quarter’s earnings report.  Long story short, everything in corporate America centered more and more around the almighty stock price.  If you want proof, look no further than what big banks did prior to (and in creating) the housing bust.  You are going to tell me that executives in those banks didn’t know that making 100% loans to people with no income was dangerous?  Come on.  Once one of them did it – and the others saw how much it was benefitting their stock prices – it was all hands on deck.

It makes sense, right?  After all, we all want to invest in companies designed to fully maximize profit.  I don’t disagree.  But we also have to bring in the wonderful politicians.  They had already perfected ignoring the long-term health of their business – that being our country - in favor of the next election cycle.  Problem is, the inflation rate on campaign financing was dwarfing healthcare, education or any other rapidly inflating cost out there.  I mean, it takes serious money to create phony reports tying your opponent to the Russians!  (sorry, it was just too easy)  Enter large corporations (Wall Street again in the center), the wealthiest individuals, unions and any other large organizations with money to spend on political favor toward their agenda.  That’s the ticket!

For the time being, we are going to ignore the unions, the NRA and the elite wealthy going forward as they have less to do with this tax cut and more to do with societal issues.  Let’s focus on the corporate donors.  As a reminder from previous updates, stock prices are supposed to be a function of earnings.  Simply put, rising earnings should lead to a rising stock price and vice versa.  Let’s do a quick and overly simplified analysis of strategic decisions a corporation can make, and their effects on short-term earnings:

(1) Raise Wages =                                   Wage Expenses Up, Earnings / Share Down

(2) Hire additional employees =         Wage Expenses Up, Earnings / Share Down

(3) Invest in Plant & Equipment =      Operational Expenses Up, Earnings / Share Down

(4) Buy Back Stock =                               Shares Outstanding Down, Earnings / Share Up

So if you share our belief that corporate America has become increasingly short-sighted in their decision making – with a keen eye toward protecting their stock price – then which of the above decisions do you think CEOs and boards are most likely to gravitate toward when handed a boatload of free cash?

Then we have the most short-sighted and self-serving creatures on the planet – otherwise known as politicians – telling us that corporations will instead accept this huge gift of cash and immediately begin expanding, hiring and giving out raises to their employees.  Almost instantly, corporations began very publicly announcing their “$1k / employee bonuses across the board”.  Winks and nudges all around.  What the hell happened to draining the swamp?  I digress…. 

Look at the chart below, and ask yourself one simple question:  

If multi-billion dollar corporations were taxed so unfairly, how were their profits already growing at this kind of pace?  Furthermore, if profits were already near all-time highs before this gift – then why weren’t wages and jobs rising correspondingly?  For an answer, look back a few sections to what helps and hurts earnings and stock prices.  Unfortunately, lowering tax rates doesn’t change this at all.  But it does significantly raise excess cash for companies to buy back their stock…..and keep those political donations rolling!  Not surprisingly, January of 2018 brought the highest level of announced stock buybacks in recorded history.  I don’t doubt for a minute that political donations from corporations are about to follow suit.

It must be noted that these tax cuts are hardly without benefit.  In fact, I will take just about any scenario where you take money away from our government and give it back to the private sector.  Will we see more investment in the US vs abroad because of the tax cuts?  Almost certainly – and that will create jobs.  I’m less certain on the wage side of things, but it’s hard to argue that most corporations have increased flexibility if they choose (or need) to do so.  In the end, I have my own litmus test as to whether or not these tax cuts accomplished what the politicians promised.  If two years from now, I still dread calling customer service of any large corporation because of automated systems eventually leading to a live person who barely speaks English – I will know that the money ultimately went to buying back their own stock.  I’m not holding my breath for sure.

Oh yeah, we haven’t even discussed the deficit / debt ramifications of this tax plan.  That’s the “disastrous”, long-term effects that we refer to – adding even more deficit / debt without any plans to pay for it.  More on this to come in future updates for sure…..

Of course, the point of all of this commentary was to lead into our economic / market outlook for 2018.  For those of you reading along, waiting for us to give an exact, year-end number for the S&P, DOW or 10 year treasury – you are about to be disappointed once again.  But this does give us the opportunity to once again remind those looking for such predictions that a local Tarot Card reader can prove just as inaccurate, and likely much more entertaining?

Instead, we will lay out our most likely scenarios for markets and interest rates, along with our confidence level of each.  Without further delay (and noting that these should be viewed from Valentine’s Day forward for future reference)…..

What We Expect for 2018

Scenario One (highest probability) – Stocks Chug Higher, Rates Rise but Remain “Contained”

It is almost impossible to ignore the potential effects of this tax cut on the stock market.  For one, the new corporate rates increase earnings / share just by themselves.  Combine this with our belief that much of the tax savings will go to repurchasing stock, and it’s hard to imagine this not being Utopian for stocks.  Yes, valuations remain historically high using any number of metrics.  But this is also against the backdrop of the ridiculously low interest rate environment that continues to exist.  It is for this reason that interest rates – in conjunction with inflation – will continue to be what we are focusing on.  Yes, we had a wild bout of volatility earlier this year – but come to find out it had little to do with valuations and/or interest rates - and much more to do with (you guessed it) some sort of derivative-based, volatility trade widely in use across Wall Street.  

Speaking of rates, things are getting very interesting for sure.  We have always viewed 2.9-3% on the 10 year as a focal point with rates.  It represents the lower band of our own research done on historical rates.  It also represents the “breaking of a trend line” when looking at the past 30 years.  We want to see whether or not the 10 year treasury closes the year “significantly” above 3%....or not.  We think that stocks can continue to rise while the yield on the 10 year stays below 4 or maybe even 5%.  We don’t think we will get to those levels this year.  But if you want to know for sure, we might suggest asking one of those crazy eight balls – it will likely be as accurate as the last analyst you saw on TV.

Last note on rates here, the valuation conversation around stocks is going to get real in a hurry if and when we get close to 4% on that 10 year…..

Scenario Two (less likely) – Rates Explode Higher, Stocks Begin to Crack

We’ve probably said this a hundred times in the past few years (and several times already today) – one cannot possibly predict the outcome of the unprecedented Fed activity over the past decade.  Not only is the Fed continuing to raise rates consistently, but we also have the “behind the scenes” effects of QE 1-3 unwinding.  Even with all the time we spend listening, reading and watching others opine on the topic – we still have little understanding of what they are and are not doing along these lines.  To be certain, no one knows the ultimate outcome.

We find it extremely unlikely that this scenario would be caused by an over-aggressive Fed.  Remember, this is a new Fed chair – and one that was appointed by a President who has turned into the stock market’s biggest cheerleader.  But we should always remember a few very important facts:

(1) A LOT of money has gone into fixed income vehicles of all kinds

(2) Interest rates have gone down in a “straight line” over the past 30 years

(3) Governments around the globe are spending money like drunken sailors (no offense to drunken sailors, as they are much more responsible)

(4) Once again, our Fed has taken never before attempted actions over the past decade

So, while we don’t expect rates to get out of control on the upside – we certainly won’t ignore the possibility.  In this scenario, we would expect stock losses to be somewhat muted – at least this year – mainly because of the hand out from Washington.  However, we would likely be much more pessimistic at this time next year if this scenario were to play out with rates during 2018.
Scenario Three (least likely) – Stocks Plummet Back to Earth, Rates Plummet with Them

Again, we should be wary of completely ignoring valuations of stocks – even with all of the tail winds described.  Geopolitical risks are most certainly out there, and God only knows what our President may tweet on any given day.  We have some very interesting mid-term elections approaching.  And judging by the recent volatility in stocks, we still don’t know exactly what derivative-based risks exist out there that Wall Street created for itself as this free-money party has continued to rage on.

So let’s say it happened.  Stocks dropped by 20% or more for whatever reason.  Panic returned to the streets.  We might see the traditional “flight to safety” – where rates fall because investors are buying bonds with vigor.  But let’s not also forget – the Fed went all the way up to 1.50% with the Fed Funds Rate.  That means they have 1.50% to now drop before they get back to zero (or beyond).  Not to mention, we still assumptively have QE4 – QE infinity yet to go if they need it.

We find it highly unlikely for 2018 for all of the reasons discussed.  That said, we find it very likely sometime in the not too distant future.  Think we are being too pessimistic?  Well, Ben Bernanke – the Godfather of current monetary policy (now not-so-shockingly employed by Wall Street) – recently predicted that the Fed would be at negative interest rates within 5 years....

OK, just for fun – here are our year-end projections for the S&P 500, along with the yield on the 10-year Treasury.  Our projections are of course based on the analyses above.  And for the sake of our own integrity, we will add the predictions of a random coin-toss.  Since we don’t have a full working day to conduct coin-flipping activities (and so as not to insult our readers' intelligence), we will break down the possibilities very generally as follows:

S&P 500: (1) up or down < 10%; (2) up or down > 10%, but < 20%; (3) up or down > 20%

10 Year Treasury Yield:  (1) < 3%;  (2) > 3%, but < 4%;  (3) > 4% 

Here are the results:

                                                 Round Hill                                      Coin Toss

S&P 500:                                 Up > 10%, but < 20%                   Up < 10%

10 Year Treasury Yield:          > 3%, but < 4%                            < 3%

So with all of this new-found optimism, does this mean we now suggest throwing caution to the wind and loading up on stocks?  Hardly.  The environment remains a frustrating one for investors who are more conservative by choice or necessity.  It used to be that you could actually earn interest on your cash or fixed income holdings while shielding it from the stock market – that has not been the case for quite some time.  As a result, the disparity in gains between stocks and more conservative investments has been growing ever larger.

In our opinion, the overall risk to the markets – when they finally turn – are even greater as a result of this dynamic.  More and more investors are finding themselves ignoring their tolerance for risk in favor of chasing returns only found in stocks.  This is what they call “weak money” – money that will flee the market “with the first negative monthly statement”.  This is not how you want to invest.  In the past two weeks, I have had more than one client – who just two months prior were asking to be more aggressive – call to tell me they were thinking of liquidating their stock positions entirely because they “can’t afford to lose money with all of this volatility”.

There is no doubt about it, the most likely scenario that we describe above would also be the most frustrating for conservative investors.  These investors are underweight “risk assets” (stocks), while overweight fixed income and cash type investments.  When stocks are rising – while fixed income is staying flat (or even falling) – it doesn’t feel good.  These are periods where the markets will truly test the resolve of the more conservative investor….

Please, don’t ignore your risk tolerance and long-term needs because you feel like you are “missing the boat”.  It is a recipe for disaster.  One of my favorite lines in recent memory came from one of those billionaire investors that they put on TV all the time (I wish I had paid attention to the name).  The anchor asked “How did you manage to make all of that money?”  His response was simple, “I always sold too early”.

Finally, I promised earlier to revisit the reasoning behind the tardiness of this publication.  Unfortunately, last December – when I would have otherwise been feverishly compiling thoughts for this outlook – my father passed away unexpectedly, a day after his 70th birthday.  So my thoughts and energies were understandably elsewhere at the time.  Since then, every time I would sit down to write, it seemed uncharacteristically difficult.  Maybe it was because I knew how much he enjoyed reading these (and that he was one of very few who would actually do so from start to finish).  Maybe it was because I know that I have mentioned his “wisdom” on more than one occasion in these rants.  At the end of the day, I think I realized that this was ultimately going to be another “goodbye” that I didn’t really want to face…..

My father instilled many things in his three boys – none more endearing than the importance of honesty and integrity.  There were never any lectures on the topic, in fact I don’t recall ever hearing the words come out of his mouth.  He taught us the old fashioned way – by example.  The man did not care about money, except to the extent it would allow him to take care of his family.  He cared even less about image.  He of course had his faults – impatient, opinionated and stubborn as a donkey to name a few.  But my father could look in the mirror each morning, and be truly fulfilled with what was staring back at him.  That is a blessing for anyone.

Over the past several months, Katie (our marketing director, who also completely runs the office at this point) has been imploring us to create a more official marketing plan.  Of course, one of the most critical components of a good marketing plan is specifically identifying what differentiates us from other financial planners or investment advisors.  I found myself answering the same way every time – “that we are not completely full of shit”.  And each time, Katie reminded me that those sentiments might not make for the most appealing cover of a brochure, or home page of our website.  We certainly couldn’t get it by compliance.  Still, I love the idea.  “Round Hill Wealth Management – We’re not Completely Full of Shit.”

That sounds very arrogant, like we are stating that we have all of the answers while others do not.  That could not be further from the truth (we’re lucky if we have even a few of them).  In fact, we are saying just the opposite – we acknowledge and communicate every day that we do not have all the answers.  In this business, the reality is that no one does.  We would rather focus on what a client truly needs, rather than sell a bunch of Wall Street hype.  It's not a sexy stance to take, nor is it a popular one in our industry.  It won’t get us invited to speak on CNBC, and it doesn’t lend itself to exploding the size of our clientele.  But it is honest and it is real……and we are just fine with that.

So Dad, in case you are reading this from above, I don’t think I’m going to be able to sneak that slogan in.  But I promise that the sentiment will always remain.  

To all of our clients, we can never thank you enough for the trust and confidence you continue to place in Round Hill Wealth Management.  

The opinions expressed in this material are for general information only and are not intended to provide specific advice or recommendations for any individual.  

Statements of forecast are for informational purposes and are not guaranteed to occur.  Trends discussed are not guaranteed to continue in the future.  

All performance referenced is historical and is no guarantee of future results.  Investments mentioned may not be suitable for all investors.  

Equity investing involves risk, including loss of principal.  No strategy – including tactical allocation strategies - assures success or protects against loss.  

Bonds are subject to market and interest rate risk if sold prior to maturity.  Bond values will decline as interest rates rise and bonds are subject to availability and change in price. 

Government bonds and Treasury bills are guaranteed by the US government as to the timely payment of principal and interest and, if held to maturity, offer a fixed rate of return and fixed principal value. 

Securities offered through LPL Financial. Member FINRA/SIPC. Investment advice offered through HighPoint Advisor Group, LLC, a registered investment advisor.  HighPoint Advisor Group, LLC and Round Hill Wealth Management are separate entities from LPL Financial.