Lots of cash and animal spirits: What could possibly go wrong?

If you’ve ever been to a particularly raucous New Year’s party, you know that there’s a logical progression from the first awkward arrivals and introductions until you’re sleeping in a car full of raccoons and empty Cheetos bags.  And, at the time, each step makes wonderful sense.

Right now, the markets are at a spot where spirits are high and cash is flowing like liquor at your broker’s annual Christmas party. Let’s take a look at the animal spirits first.

University of Michigan, University of Michigan: Consumer Sentiment© [UMCSENT], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/UMCSENT, January 1, 2017.

 University of Michigan, University of Michigan: Consumer Sentiment© [UMCSENT], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/UMCSENT, January 1, 2017.

As you can see, consumer sentiment has been rising since the dark days of 2009; it now stands at 98.2 — the chart is lagged by a month. Sentiment is now higher than it was in January 2015 (98.1), and the highest since February 2004.

Soptimism-graphmall business confidence is also up post-recession, but it jumped markedly after the election, presumably on the hopes of lower taxes and regulation by the new administration.

And that confidence — plus the 12% gain by the Standard & Poor’s 500 stock index this year — has sparked optimism among investors. The American Association of Individual Investors sentiment survey now stands at 45.6% bullish, vs. its 38.5% historical average. Similarly, just 25.7%  of those surveyed said they were bearish, vs. a historical average of 30.5%. Bullish sentiment is at a five-week high, and its third-highest level of 2016.

At the same time, there’s plenty of money on the sidelines, and some of it appears to be returning to stock funds. In the last week of 2016, investors poured an estimated $118 million into U.S. stock funds. But that’s a piker compared to the previous week, when an estimated $18.6 billion flooded — more than the previous 24 months combined, according to the Investment Company Institute, the funds’ trade group.

As of the end of November, there was $2.7 trillion in money market mutual funds, earning approximately zilch. A roaring stock market provides a great deal of temptation for at least some of that money.  Stock funds had about 3.2% of their assets in cash, which is not particularly high, and that figure’s usefulness has been eclipsed somewhat recently.

Another potential source of cash: Companies in the S&P 500 have a record $1.5 trillion in cash cooling its heels on their balance sheets. They can use this for buying back stocks, paying dividends, or — and this is crazy talk — reinvesting in plants, equipment and their own employees.

The bad news is that the stock market is already expensive. The S&P 500 sells at about 24 times earnings, as opposed to a historical norm of about 17 times earnings. S&P predicts that earnings will rise through 2017, bringing down the PE ratio to about 18. Bear in mind that forecasts are notoriously unreliable, particularly when they’re about the future.

Bear in mind, too, that the Federal Reserve is likely to continue to raise interest rates, and at a faster pace if the economy grows faster than expected.

Right now, it looks like animal spirits and plenty of cash will keep the market party going, and that can be good, clean fun. Enjoy the ride. Just remember that market rallies always last longer than a sober person would think. But remember that many things must go right for the rally to continue. It’s probably a good time to readjust your portfolio back to your original goals. No one ever went broke taking a bit of profits.





Greetings from Lacunaville

SDSC_0368tarting in January, I’ve been writing full-time for InvestmentNews, doing a monthly column for Money magazine, and studying for the Certified Financial Planner mark. (This, apparently, is also a test of your prowess with a hand-held calculator). And I went to Africa.

The blog, as you may have noticed, has, um, languished. I’m hoping to revive it on a somewhat irregular basis, which, come to think of it, is pretty much its usual schedule.

I’ll be updating my links pages in the next week or so. In the meantime, here are some things to watch for today, as well as some things I’ve found interesting or peculiar.

This week, all eyes are on the Bureau of Labor Statistics’ employment situation report, out at 8:30 a.m. Friday. But the stock market seems to be resigning itself to an interest rate hike, probably in June or July. (A later hike would give the impression of a political motivation, and the Fed generally doesn’t like to do that). The current consensus estimate for new nonfarm jobs is 158,000, according to Bloomberg, with the unemployment rate falling to 5%. (And, yes, the total unemployment rate is still high, but it’s the nonfarm payrolls number that Wall Street watches.)

Wages also seem to be firming up, and it should be interesting to see if traditional summer employers, such as ice cream vendors and lawn mowers, have a hard time finding help this year. All of these would seem to give the green light to the Fed to raise rates.

Of course, we’d be talking about a lordly fed funds rate of 0.5% to 0.75% after a Fed hike, an increase that will be promptly reflected in your credit card bill and eventually in your money market mutual fund account. For those who still watch their money fund account, the average money fund now yields 0.10%, nearly triple its rate at the start of the year.

DSC_0353The stock market typically dislikes interest-rate hikes. Higher rates mean bonds become more competitive with stocks, and increase short-term borrowing rates. On the other hand, higher short-term rates mean that companies will earn somewhat more on their cash, and that savers will earn slightly more on their cash.

The old adage about Fed rate hikes — three steps and a stumble — meant that the stock market takes the first two hikes as a sign that the economy is improving, and rallies. At the third hike, stock investors realize the Fed wants the economy to slow, and stocks sell off. Bear in mind that the adage originated when a normal fed funds rate was 4% to 5%. It would take a stairway, not a few steps, to get us back to the traditional stumble level, assuming the Fed raises rates at a quarter-point a pop.

I’m an optimist, and think that rising earnings are a good thing — in fact, the one thing that the economy desperately needs for sustained growth. Most companies, despite their complaining, have nice profit margins, good balance sheets, and plenty of cash. They might even be surprised to learn that when their employees get raises, they spend more — and even on the products their employers sell.

DSC_0488The one caveat: Stocks aren’t cheap, at least by the price-to-earnings ratio of the Standard and Poor’s 500 stock index. The current PE, based on forward earnings estimates, is 17 — a tad feverish, although nothing like the levels during the technology bubble. Nevertheless, at these levels, it’s a bit like driving a bit too fast on old tires. If the market takes a rate hike really badly, investors could find that both bond and stocks slide off the road. And in that case, having a bit of cash in a money fund might be a good safeguard.


The week ahead

Only two things matter in this first week of the new year: China and jobs. And China, frankly, isn’t looking too good.

The market plunged at the open Monday on news that Chinese manufacturing was far worse than Wall Street expected. The Chinese purchasing managers’ index fell to 48.2 last month, vs. 48.6 in November, it’s 10th consecutive decline. When the index is below 50, the manufacturing sector is in recession.

The Chinese stock market took one look at the numbers and promptly plunged 7% before circuit breakers kicked in. Wall Street took a sober look at the Chinese market’s reaction and promptly panicked. The Dow Jones industrial average is down 318 points, or about 1.8%, as I write this.

China takes these things seriously: So seriously that Chinese CEOs are starting to mysteriously disappear. If I were a Chinese CEO today, I’d be hastily packing my bags.

The stalling Chinese economy will weigh heavily on the U.S. market, since so many U.S. companies have been counting on China for increased sales and growth. So today, the stock market will be digesting this news, and discounting stocks across the board.

fredgraphAfter that, Wall Street will spend the rest of the week fretting about jobs. And there are all sorts of indicators to watch in the run up to Friday’s jobs report. (Which, for the record, is expected to show 200,000 new jobs in December, vs. 211,000 in November.)

  • Tuesday is motor vehicle sales, which should show fairly robust growth in what was once the nation’s largest employers. Analysts are expecting fairly robust gains in December, thanks to low gas prices and the prospects of modest raises in 2016. Another factor: The average U.S. auto is more than 11 years old. Cars age better than they used to, but there’s a lot of pent-up demand for new cars.
  • Wednesday is the ADP Employment report, which is a pretty good predictor of how the Friday jobs report will turn out. The consensus on the report, which excludes government jobs, is for 190,000 new jobs in December.
  • Thursday is the volatile weekly unemployment claims report, has ticked up to the highest levels since July, when the numbers flirted with lows unseen since the Nixon administration. Another important report is the Challenger Job Cut Report, which measures mass layoffs. Many companies choose to lay off employees just in time for the holiday season, so it should be an interesting report.


How the naive are faring

You could line up all the advisers from here to Albuquerque, and you still wouldn’t reach a conclusion as to the best diversified portfolio for your retirement savings.

Because of that, many investors simply use the 1/n portfolio — which is to say, they divide their money equally among all the options in their 401(k) plan. Among those who study these things, this is called the Naive Portfolio.

What would a Naive Portfolio look like? Most 401(k) plans are not exactly paragons of fund-picking: They often choose the largest funds. After all, those funds typically have decent long-term records and low expense ratios, and no one is going to get sued using those criteria.

Let’s compose a naive portfolio of the 10 largest mutual funds. It would look like this, ranked by size:

Tot. ret. Tot. ret.
Fund Ticker Category 2015 5 years
Vanguard Total Stock VTSMX Large blend 2.37% 13.98%
Vanguard 500 Index VFINX Large blend 2.89% 14.23%
Vanguard Total Intl Stock Idx VGTSX For. large blend -2.35% 3.30%
Vanguard Total Bond VBMFX Interm. bond 0.68% 2.86%
Growth Fund of Amer A AGTHX Large growth 6.98% 13.78%
Europacific Growth A AEPGX For. large growth 1.57% 5.49%
Vanguard Prime MM VMMXX Money market 0.03% 0.03%
Fidelity Cash Reserves FDRXX Money market 0.01% 0.01%
JPMorgan Prime MM VPMXX Money market 0.01% 0.01%
Fidelity Contrafund FCNTX Large growth 7.93% 13.87%
Average 2.01% 6.76%

Source: Morningstar.

So how did our naive investors do? At least this year, they have done pretty darn well. The average expense ratio in this portfolio is 0.35%, which, honestly, you can’t beat with a stick.

Furthermore, a 2% return is just a shade lower than what you would have gotten with a single investment in the Vanguard Total Stock Index fund. And you would have gotten that return with far less risk than a pure stock index fund, given that 30% was in money market funds and 10% in bonds.


Just how successful a naive investment would be over the long term is a more difficult calculation, which I’ll tackle in future posts. But the takeaway is that naive diversification is probably better than no diversification at all.




Golden slumbers

If you’ve ever looked at a St. Gaudens double eagle, you understand the allure of gold. Beautiful as it is, though, gold is a really bad thing to base your monetary system on.

Augustus St. Gaudens (1848-1907), was one of the premier artists of the Beaux-Arts generation whose works include the monument to Robert Gould Shaw and the 54th Massachusetts regiment that stands on the Boston Common. He designed the coin at the request of president Theodore Roosevelt, who wrote to his Treasury secretary,”I think the state of our coinage is artistically of atrocious hideousness. Would it be possible, without asking permission of Congress, to employ a man like Saint-Gaudens to give us a coinage which would have some beauty?”

double eagleWell, St. Gaudens certainly did. The St. Gaudens double eagle, with its figure of Liberty striding in the morning sun, is a remarkable piece of numismatic art. The coin was 90% gold and 10% copper — pure gold is too soft for coinage meant to be handled by the public — and weighed nearly an ounce. Its face value was $20.

At today’s prices, discounting for the copper, a double eagle would be worth about $944. Just as a point of reference, $20 in greenbacks from 1907 would be worth $500, according to this handy inflation calculator. 

Those who sigh for the days of hard money should sigh for beautiful coinage instead. In the first place, the free market had very little to do with the gold standard: The government set the price of gold. And from 1900 through 1933, you could always cash in a $20 bill for exactly one double eagle, because that’s the price the government set. (The government raised the price to $35 during the Depression, effectively inflating the currency).

Furthermore, the supply of gold wasn’t static, either. The government could add or decrease its gold reserves through buying it on the open market, just as the Federal Reserve can now. Big gold strikes, such as in California and Alaska, could goose the gold supply and push up inflation. And one reason for the Crash of 1857 (who can forget that?) was the sinking of the S.S. Central America, which sent 30,000 pounds of gold to the bottom of the ocean.

Being on the gold standard didn’t shield the economy from financial crises: In 1907, the same year the St. Gaudens double eagle made its debut, Wall Street had one of its most severe financial meltdowns — the “Rich Man’s Panic,” which was alleviated only by J.P. Morgan strong-arming the wealthiest men in the nation to be the lenders of last resort. The stock market fell nearly 50% in just three weeks. The experience in 1907 led to the creation of the Federal Reserve in 1913.

Finally, there’s just not enough gold in the world to go back to the gold standard. There are about 170,000 metric tons of gold in the world, according to the World Gold Council. That’s about 5.5 billion troy ounces, or $5.8 trillion. The U.S. economy is about $16 trillion — and we don’t own all the gold in the world. Either the price of gold would have to explode, or the economy would have to contract. And even then, we’d be at the mercy of gold producers in Russia and South Africa for our money supply.

I don’t have a particular opinion on the future price of gold, although it’s still above its average price of about $500 an ounce since 1974, when President Gerald Ford lifted all restrictions on the price of gold. I do think gold coins are pretty, though, and if you want to own gold, that might be the best reason.

Seeking Alpha

According to — well, just about everyone — it’s nearly impossible to beat the Standard and Poor’s 500 stock index for any prolonged period of time on sheer cunning alone. Those who do may owe more to chance than to skill. And for that reason, your best investment bet is a low-cost index fund, such as the ones in the Amish Portfolio.

From the wonderful The Brokers With Hands On Their Faces Blog (http://brokershandsontheirfacesblog.tumblr.com)

If there is any hope for active management, it’s in small markets where 1,000 analysts aren’t looking at each stock — such as small and micro-cap companies. The problem with small companies is that they have an unfortunate tendency to become much smaller companies, at which point they become former companies. And many small-company stock funds have to sell small companies when they become too large. Imagine if you had done that with Apple.

Nevertheless, if you’re hoping to get a boost from active management, small-cap funds are probably the place to look. And small-company value funds, which look for unappreciated and cheap companies, might be the best part of of the small-cap universe to look. One of the many questions about looking for a small-cap fund: Is the fund performing well because it’s taking outrageous risks?

Fortunately, there’s a stat for that, and it’s called alpha, which measures a fund’s return in relation to the risk it takes. A fund with an alpha greater than 1 gives off more return than one would expect, given the risk.

Risk, in this case, is determined by beta, which measures how a fund relates to an index, such as the Standard and Poor’s 600 small-cap index. A fund with a beta of 1 runs in lockstep to its index. One with a beta below 1 will rise or fall less than its index; one with a beta above 1 will rise and fall more. Basically, you want a fund with an alpha above 1 and a beta below 1.

Finally, you want a fund that’s not too large. Most funds won’t buy more than 5% of a company’s outstanding stock. Small-cap stocks, by definition, have about $1 billion or less in shares outstanding. Suppose a fund liked a stock whose outstanding stock was worth $500 million. The fund could buy a maximum $25 million of the stock. If the fund had $2 billion in assets, the position would be just 1.25% of the fund’s assets — a relatively small stake.

So: If you’re looking for a small-cap value fund that actually adds value, look for one with an alpha greater than 1, a beta less than 1, and assets less than $1 billion or so. And if these managers are truly cunning, consider selling them if the rest of the world catches on. Sooner or later, their success will translate into higher assets, and that, in turn, will make it harder for them to succeed.

Some caveats: The S&P 600 small-cap index has risen an average 15.42% the past three years, and small-company value funds typically lag in a red-hot small-cap market. This has been the case recently: The average small-cap value fund has gained 13.17% during the same period. It’s usually best to buy small value after a market meltdown, so there’s clearly no hurry. And several of these funds are microcap funds, which invest in companies small enough to fit into a mouse’s teacup. With all that in mind, here’s the list.

Fund Ticker Total return 2015 Total return (annualized) 3 years Alpha Beta
James Micro Cap JMCRX 7.3% 21.3% 7.00 0.96
Ancora MicroCap C ANCCX -3.4% 15.8% 3.44 0.92
Emerald Small Cap Value Institutional LSRYX 3.8% 15.0% 2.91 0.92
Great-West Invesco Small Cap Value Init MXSVX -0.6% 14.8% 2.44 0.97
Perritt Ultra MicroCap PREOX -1.1% 14.7% 5.42 0.55
Ancora Special Opportunity C ANSCX -1.0% 13.9% 1.90 0.86
Nationwide Bailard Cognitive Value M NWHFX 2.2% 13.6% 2.20 0.92
Queens Road Small Cap Value QRSVX 2.8% 13.1% 4.06 0.70
DGHM V2000 SmallCap Value Instl DGIVX 1.2% 12.4% 1.57 0.89
Small Cap Value SCAPX -13.6% 7.9% 7.99 0.93
Pinnacle Value PVFIX -1.2% 7.5% 2.62 0.37
Cozad Small Cap Value I COZIX -6.6% 0.0% 1.44 0.96



On deck this week: Housing ‘n’ earnings

If you own a home, you’ve probably become addicted to real estate porn. This is not, as you might suspect, movies about bodice-ripping real estate agents and muscular roofers. Instead, it’s any of a number of real estate sites, such as Zillow, that let you find out what your neighbors are asking for their homes, what they paid for it, and, sometimes, what their taste in kitchen flooring is like. “Really? Bamboo? Oh. My. God.”

We’re fascinated by housing in part because we’re Americans, and owning a home is still a part of the American Dream. And we’re also convinced, despite compelling evidence to the contrary, that real estate is the road to riches, even if tapping those riches means living in the woods.  This week, there’s plenty of news coming about housing, and it’s worth paying attention to, even as companies continue to trot out their third-quarter earnings.

housingWhy look at housing stats when you can have more fun gasping at your neighbor’s marble Jacuzzi? Housing is a powerful engine for the economy. When you build a home, you’re employing dozens of people in well-paying jobs, racking up enormous purchases in timber, wire, and shingles, and setting yourself up for substantial further purchases for furniture, housewares and lawn gnomes.

Furthermore, the housing industry has yet to recover from the 2007-2009 financial crisis.  New housing starts are at 1993 levels. And the median home price — half higher, half lower — has yet to break its 2006 peak.

This week, we’ll get several views of the housing market, starting with the Housing Market Index from the National Association of Home Builders, released Monday. The index is based on a survey of the association’s members, and it has been fairly chipper lately. The supply of new houses is low, as are mortgage rates — now averaging 3.82% for a 30-year mortgage.

Tuesday, the Bureau of the Census releases its housing starts data. As you can see, it still has a long way to go before it climbs out of its deepest hole since the series started.

Thursday comes existing home sales from the National Association of Realtors. Calculated Risk, one of the best blogs on housing and the economy, thinks the number will be stronger than most economists predict. For home price voyeurs, The Federal Housing Finance Agency House Price Index gives a read on how single-family home prices are doing. They have risen about 6% the past 12 months.

Long-term investors should keep their eye on housing data, because it’s so important to the economy. But it will be earnings that catch the market’s eye first. It’s peak earnings week, with 110 companies reporting:

  • Monday, Haliburton will likely release a woeful earnings report; IBM, Morgan Stanley and Broadcom are also on deck.
  • Tuesday: Yahoo!, Verizon and Lockheed Martin
  • Wednesday: Abbott Labs, American Express, eBay, Boeing, General Motors, and Texas Instruments
  • Thursday: 3M, Amazon, Caterpillar, Southwest Air
  • Friday: Procter & Gamble, State Street, American Airlines

So far this year, earnings haven’t been great. They’re down 5.14% from the third quarter of 2014, the first year-over-year decline since 2009. It will take a lot of happy housing news to counter any major earnings disappointments this week.