The convergence of the twain

And as the smart ship grew

In stature, grace, and hue,
In shadowy silent distance grew the Iceberg too.

Thomas Hardy, The Convergence of the Twain (Lines on the loss of the Titanic)

 

Thomas Hardy’s poem makes sardonic note that, while the Titanic was taking form in Liverpool shipyards, so, too, was the iceberg that doomed it. And, while each bull market grows, so do the forces that will eventually cause it to stop.

What will cause the death of this bull market? No one really knows, and the nature of a bear market is that few see it coming. But if I were to put money on it, the most likely assassin would be the Federal Reserve, rather than disappointing Facebook earnings.

The Fed’s job is to keep the economy on a sustainable growth rate, which means that the economy should grow fast enough to keep unemployment low without inflation. (To the cognici, this is the non-accelerating inflation rate of employment, or NAIRU, which sounds like something out of the Mork and Mindy Show.) Just what NAIRU is is a matter of debate among economists. It’s enough to know it exists.

When the economy is sluggish, the Fed lowers short-term interest rates, which makes it cheaper for companies to borrow and invest. It allows people to refinance mortgages and other debts at a lower rates – essentially, putting money into their pockets.

When the economy is growing too fast and inflation is rising, the Fed raises short-term interest rates to slow the economy. When rates rise, it’s more expensive to borrow, which slows the housing market and makes companies more wary of borrowing.

While the Fed may say that it doesn’t want to cause a recession or slow down the stock market, rising interest rates often do both. A recession wipes out wage inflation: You can’t have wage inflation if people are getting laid off, and you can’t have a wage-price spiral without rising wages. Most stock investors know that higher rates can augur recession, and they tend to sell stocks as rates creep higher. And, on a technical note, stock analysts tend to reduce price targets when interest rates rise.

The most famous example of the Fed crushing stocks and the economy was in 1981, when the Fed hiked short-term interest rates to the highest in modern history: The three-month Treasury bill yielded 16.3% in May of that year, and a sharp recession followed. Inflation, as measured by the Consumer Price Index, fell from 9.79% in May 1981 to 2.36% by July 1983.

But most other bear markets have been preceded by rising rates: The 1987 market crash, for example, as well as the 2000-2002 tech wreck and the 2007 financial meltdown all had rising rates at their backs. While none of those rate hikes were as severe as in 1981 – and you can debate whether they were the proximate cause of the bear market – few bear markets start after a prolonged period of the Fed cutting rates.

What does all this mean? If you have ten or more years to reach your savings goals, not a thing. In fact, a bear market is a good thing if you’re young and contributing regularly to a stock fund in a retirement account. You get the chance to buy stocks cheap over a long period of time.

If you’re close to your goal, however, you should at least think about how much you have in stocks. The most logical way is to rebalance: If you set a goal of 60% stocks and 40% bonds, for example, you’re probably out of balance now. It wouldn’t hurt to sell enough stocks and buy enough bonds to get back to that 60% and 40% risk.

Buybacks hit new record: Should you care?

Let’s listen to the latest board meeting of Twango, the highly profitable and entirely fictitious company that makes banjos for Latin dance bands. Thanks to an inexplicable surge in banjo-fueled Tango raves – and a major tax cut – Twango is showing record profits this year.

“What are we going to do with all this money?”, asks the CEO. “Should we give the workers a raise?”

“Heck, they got 1% last year,” the treasurer says. “That’s 1% more than everyone else in the country got.” (No, really.)

“Why not raise the dividend?”

“If we do that, we’ll have to pay the increase for eternity,” the treasurer says. “Don’t know if we want to risk that.”

“How about expanding the factory? Increase advertising? Expand to Europe?”

“Whoa, whoa, whoa,” says the Treasurer. “Someone needs to switch to decaf.”

“Ok, then, let’s buy back some stock.”

“Great idea!” says the board.

While this is entirely fiction, it’s not implausible. Companies spent a record high $189.1 billion in stock buybacks in the first quarter, according to Standard & Poor’s. All other things being equal, buybacks should shrink the number of shares outstanding, thereby making remaining shares more valuable. And you can stop a buyback program with a phone call, and no one on Wall Street will say boo. Aside from showing a lack of imagination, what’s wrong with buybacks?

Ever tried to find a picture of a stock buyback? Here’s a nice giraffe photo.

For one thing, an announced buyback program doesn’t really mean anything if the company doesn’t actually buy back stock, and this is an annoyingly common practice. For another thing, many buyback programs are simply a way to pay off executive options. If our Twango CEO exercises his options for 10,000 shares, the company has to get that stock from somewhere, and it’s usually via a buyback program.

Finally, many companies, like many individuals, aren’t particularly good at buying back their own shares. In 2008 and 2009, buyback programs died like a lawn in the middle of a heat wave. Even now, the excellent insiderscore.com has a long list of companies that are buying back shares at high prices.

At least at the moment, buyback strategies haven’t been producing dividends. Invesco BuyBack Achievers ETF  (PKW), the largest and oldest buyback ETF is down 3.31% this year, while the Standard & Poor’s 500 stock index is up 2.46%. The ETF buys shares of companies that have reduced their share count by 5% or more in the past 12 months. Top three holdings: Walt Disney, American Express, and Procter & Gamble.

SPDR® S&P 500 Buyback ETF  (SPYB) is a newer, smaller entrant into the buyback field. It screens stocks based on the cash value of the actual (not announced) buyback, rather than on the reduction of shares outstanding. The ETF is up 1.58% this year – not better than the S&P 500, but better than the Invesco ETF.

Those looking for companies that seem willing to invest money in the business might check out the Nasdaq US CapEx Achievers Index (CAPEXA). The stocks in the index have increased their capital expenditures for at least three consecutive years. At the moment, there doesn’t seem to be an ETF modeled on the index. Top three holdings: Procter & Gamble, Chevron and Oracle.

Buyback strategies, like most strategies, work best when Wall Street thinks they will. And from 2009 through 2013, buyback strategies worked very well indeed. Lately? Not so much. At least at this point in the economy, it might be best to buy stocks of companies that know how to use their money to grow their business – instead of ones that can’t think of anything better to do with it.

 

 

 

Tracking the MSM

Even if you hate the mainstream media, here’s an MSM you can learn from: The Main Street Meter, via the Leuthold Group.

The MSM is the level of consumer confidence, as measured by the University of Michigan Consumer Sentiment Index, divided the unemployment rate. And right now, the MSM index is pretty high – and it has been for a while. (You can see the charts and read the article here) Good news, right?

Not exactly. Jim Paulsen, Leuthold’s chief investment strategist, notes that when the MSM index is high, investors tend to be frisky – more motivated by greed than fear. More troubling, though, is that with low unemployment, other troubles start to emerge. Typically, low unemployment is a precursor to inflation and higher interest rates.

The MSM’s highest points since 1960 have been 1968, 2000 and now. While this doesn’t mean that the stock market is going to collapse tomorrow – or even over the next few years, it does mean that the outlook for the next five years or so isn’t terribly good.

A high MSM does indicate that it might be a good time to add inflation-sensitive investments, such as real estate and commodities, to your portfolio. Typical late-cycle stock sectors, such as energy, materials and industrials, might fare well also.

Mr. Paulsen cautions that the MSM is not a good short-term market predictor, something it shares with that other MSM. But for those with the long term in mind, it’s an indicator worth following.

 

Why buy bonds?

Why do economists continue to give interest-rate forecasts, despite the fact that they’re generally awful at predicting interest rates? Probably because people ask them to. But if you’re thinking of investing in a bond fund now, it would help to have a forecast in mind – if only to give you an idea of the risks you’re incurring.

People ask economists to give interest rate forecast because so many things depend upon your assumption for rates, and that’s especially true for bonds. Bond prices fall when interest rates rise and they rise when interest rates fall.

Just how vulnerable is your fund to interest-rate changes? You can get a good idea by looking at the fund’s duration, which tells you how much a bond’s price will fall, given a rise in interest rates of one percentage point. Consider the Vanguard Total Bond Market Index Fund ETF (BND), the largest bond ETF, which is also a good proxy for, well, the total U.S. bond market.

The Vanguard ETF, for example, has a duration of 6.09 years, meaning a rise in rates of one percentage point would mean a principal loss of about 6.09%. That loss would be offset, somewhat, by the interest investors receive from the bonds. The ETF has a yield of 3.13%, according to Morningstar Direct. If you were to assume that rates will rise by a percentage point, your total return – price decline plus interest – would about a 3% loss.

Interest rates have been rising since July 2016, when the bellwether 10-year Treasury note hit an all-time low of 1.38%. It’s trading at 2.85% now. Since that date, Vanguard Total Bond Market Index Fund ETF has lost 1.75%, including reinvested interest. While interest payments have certainly offset most of the fund’s losses, it hasn’t been enough to eliminate them entirely. The past 12 months, the fund has lost 0.82%.

Army ants.

Here’s where the forecast comes in. If you were to assume that interest rates will rise a percentage point in the next year, you should brace yourself for roughly a 3% loss. That’s not a catastrophic loss – bond bear markets are like getting attacked by very mean ants – but you might consider a few other options.

One is a money market fund. Just as the 10-year T-note yield has been rising, so has the yield on money market funds. Vanguard Prime Money Market Fund Investor Shares (VMMXX) has a yield of 2.02% and – assuming the fund maintains its constant price of $1 per share – it has very little potential for a principal loss.

Another is a fund with a tolerable track record of managing interest-rate risk. (Typically, these funds are also deft with credit risk – buying bonds from shaky companies that are getting better). One is Dodge & Cox Income (DODIX). It has a duration of 4.2 years, a 3.02% yield, and an expense ratio of 0.43%.  The past two years, the fund has averaged a 2.94% gain – not much, but better than the average fund.

Bear in mind if bonds are a part of a long-term plan, you shouldn’t dump your bond funds because you’ve got a feeling rates will rise.  Over the long term, bonds have a great record in dampening the effects of stock downturns. But if you’re trying to figure out where to invest money now, a money fund or Dodge & Cox Income are two good places to start.

The monster under the bed

Alfred E. Neuman

One of the fun things about being a personal finance writer is the number of “Dear idiot” letters you get. Stories about the Federal Reserve Bank tend to get them. (“You idiot! Don’t you know the Federal Reserve is evil?”). So do stories about taxes. (“You idiot! Don’t you know that Girl Scout cookies are deductible?”)*

Inflation is another source of contention, particularly if you note that inflation has been moderate, which it has been, whether you’re using the Consumer Price Index, the GDP Price Deflator, or even the Billion Prices Project. But your perception of inflation depends on what you spend the most on. If you have kids in college or if you rely on prescription drugs, your personal inflation rate is pretty high.

Those who grew up in the 1970s and early 1980s recall when a 5% inflation rate was considered moderate, as opposed to the most recent 2.2% rate. And they fear a resurgence of inflation, with good reason: It erodes the value of retirement savings and pensions.

The consumer price index has averaged a 1.7% annual gain the past decade, and actually dipped into deflation — a period of falling prices — during the Great Recession. And the forces of deflation are still all around us: The favored tactic of technological disruptors such as Amazon, Uber and others, is to drive prices down and drive competitors out of business. This was a favored tactic of the Gilded Age, aided even further by the gold standard, which tends to favor deflation over inflation. I go on at some length about the subject here.

The Federal Reserve traditionally raises interest rates to slow the economy and cool inflation, and it lowers rates to stimulate the economy and encourage inflaton. The Fed has already nudged short-term interest rates higher five times since 2015, but rates are still extraordinarily low by historical standards. Most think the Fed is acting not out of fear of inflation, but out of fear of not having any ammunition to fight the next recession, whenever that may be.

Tomorrow’s Consumer Price Index report hits the headlines at 8:30: The consensus forecast is for a 2.1% year-over-year change for 2017. Anthing higher, particularly for the core CPI (less food and energy) is likely to make for an upsetting day in the bond market, where yields have been creeping higher and prices lower. The iShares Core U.S. Aggregate Bond ETF (AGG), a useful proxy for the bond market’s total return, has already fallen 0.57% this year, according to Morningstar.

Right now, there’s a balance between inflationary forces — a strong economy and fiscal stimulus — and deflationary ones. In the normal course of events, the Fed tightens too much during inflationary periods, causing the economy to slow, earnings to fall, and stocks to tumble. So there’s reason to watch inflation warily.

Is it time to panic? Well, no. It never is. If you’re particularly concerned about inflation, you might consider a fund that invests in Treasury Inflation Protected Securities, whose price is keyed to changes in the CPI. The current yield on TIPS shows that Wall Street expects inflation to remain at 2% the next 30 years. If you think they’re wrong, then one good pick would be Vanguard Inflation-Protected Securities Fund Investor Shares(VIPSX).

It may well be that technological changes have redefined the upper bound of inflation in the economy. Tomorrow’s CPI print is no reason to go running from the room in terror. But it’s worth keeping an eye on the monster under the bed this year.

* They aren’t, if you eat them.

The busy season for outlooks

Economists and money managers give forecasts because people ask them to, and this is the time of year when people like me ask people like them for their forecasts.

You have to take all forecasts with a grain, if not a block, of salt. Nevertheless, I got the chance to interview some smart people, such as Will Danoff, manager of Fidelity Contrafund, who’s bullish on the U.S. and technology. And then there’s Jerome Dodson, manager of Parnassus, who has the crazy notion that companies that treat employees well will prosper.

Anyway, here’s their outlooks for 2018, along with Mark Mobius of Franklin Templeton, Robert Doll of Nuveen and Joe Davis of Vanguard.

http://www.investmentnews.com/article/20180106/FREE/180109962/2018-outlook-in-equity-investing-is-mostly-bright?issuedate=20180108&sid=outlook20170108

A change of heart

A Christmas Carol is about a change of heart — in this case, the heart of Ebeneezer Scrooge: 

Oh!  But he was a tight-fisted hand at the grind- stone, Scrooge! a squeezing, wrenching, grasping, scraping, clutching, covetous, old sinner!  Hard and sharp as flint, from which no steel had ever struck out generous fire; secret, and self-contained, and solitary as an oyster.  

The spirit of Scrooge — pre-haunting Scrooge — has been alive and well in American business for a good many years. Just as Scrooge rolled up the profits of his lending business while his clerk froze, U.S. companies have only grudgingly doled out wages. The chart, left, shows average weekly wages, adjusted for inflation, the past decade. Annual rate of increase: 0.52%.

At the same time, profits, cash and profitability at major U.S. corporations have been hitting new highs. This isn’t terribly unusual: Companies typically don’t raise wages unless they have to, and they don’t have to until unemployment falls below 5% or so.

Nevertheless, workers’ share of corporate fortunes have been unusually small, especially in light of productivity improvements. Workers have produced more, but received far less of that improvement than in the past. (Keep scrolling past the graph, because I can’t figure out how to decrease the white space that follows).

 

 

 

 

 

 

 

 

 

 

 

The tax reform bill passed by Congress assumes that corporations will pass on their massive tax savings to workers, and also use that extra money to reinvest in other businesses. Will it work? It depends on who you ask, which means that no one really knows. A few companies have already announced bonuses and cited the tax reform measures as their reason for doing so.

Some, such as Wells Fargo, have waffled on whether the increase was because of the tax bill or not. Others, like AT&T, have also announced layoffs at the same time.

Nevertheless, it’s entirely possible that at least some of corporate tax savings will, indeed, make it to employee salaries, new hires or even new factories. Alas, there aren’t many funds that specialize in employee happiness. But here are a few suggestions on what might make a good investment in light of tax reform:

  • Parnassus (PSRNX). This fund takes the position that companies that treat employees well tend to do well in the long run. It’s not infallible — awful companies prosper sometimes, too — but the fund has gained an average of 10.5% a year the past decade, vs. 8.3% for the Standard & Poor’s 500 stock index.
  • Financial funds. Tax breaks plus looser regulation generally should benefit banks. SPDR Capital Markets ETF (KCE) is a good low-cost choice, as is iShares U.S. Financial Services ETF (IYG).
  • KKR & Co. LP. The private equity and real estate manager specializes in merge and acquisitions. Should companies use their newfound cash to buy other companies, KKR is a logical beneficiary.

A cynic would observe that companies have long had the ability to give their employees a raise, and have simply decided to keep most of that cash in the CEO suite. A big infusion of cash from the tax bill could simply increase those tendencies. On the other hand, we can all hope for a change of heart — although, as was the case with Scrooge, the proof was in actions, not theory.