Spring 2016 – Newsletter

Magic is the sole science not accepted by scientists, because they can’t understand it – Harry Houdini, Magician

During my sophomore year at Penn State another student sat strategically next to me during an economics exam and copied my answer sheet. I went on to receive an A, but later found out that my secret admirer scored a 34 percent because the teacher rearranged the order of the questions, something he discovered after the damage had already been done.

In my last newsletter I painted a dire picture about the economy, and according to the stock market, I could not have been more wrong. It’s important to note that a third of the $1.5 trillion in ARM loans that spelled the demise of the credit markets were scheduled to come due in 2007. Despite a predictable outcome, the S&P 500 was up 3.8 percent as late as the first quarter of 2008.

graph20For what it’s worth, the conditions I discussed have actually gotten worse, even as stocks climbed higher. With 55 percent of S&P 500 companies having already reported results as of this writing, overall earnings are set to decline by 6.1percent in the first quarter compared to a year earlier, while revenues are expected to fall by 1.4 percent.

Remember when the economy was doing so well that the Federal Reserve had to raise rates? In recent comments Janet Yellen acknowledged the obvious, that there is minimal inflation and corporate profits are declining. As benign as that may sound, there has never been a period in history where corporate profits have declined for two consecutive quarters on a year over year basis without a market crash. Well, we’re on pace for it to slip a third straight quarter in the longest earnings slide since the financial crisis.

What most of us fail to realize is that outside of the central bank intervention and balance sheet gimmicks, the end of a business cycle is very normal. It starts with high unemployment, which leads to low labor costs that allows companies to spend money and expand. Wages begin to increase, the cost of doing business goes up and high unemployment returns. When I was a teenager I tried on a leather coat I just bought and told my parents how warm it was. My dad replied “maybe that’s because you’re inside.”

Of course, there’s a very good reason this feels odd. A couple of generations ago cattle weren’t slaughtered until they were around five years old – today it happens at fourteen to sixteen months. This is made possible with lots of corn, protein, fat supplements and a stream of pharmaceutical drugs. Our economy stopped eating high fiber grass some time ago, so the idea that a business cycle can end seems unnatural to the consumer of financial assets.

So what exactly transpired over the last couple of months? Essentially several short term events impacted price movement. The first thing that happened was the value of the U.S. dollar declined by 6 percent from its high. Keep in mind that when the dollar drops, products manufactured or produced by American companies are cheaper when they’re exported to other countries and markets assume this competitive advantage will lead to higher profits.

The reason the dollar slumped is two-fold. First, Federal Reserve Chairwoman Janet Yellen acknowledged that the economy is not growing, and on that news the market discounted her willingness to raise interest rates. As you likely surmised by now, lower interest rates make our currency less valuable and increases the present value of future cash-flow.

graph21The second reason is that both Japan and the European Union have been making gargantuan attempts to stimulate growth by hook, crook or public policy, which to some might sound redundant. They believe that massive amounts of stimulus (i.e. Quantitative Easing 1, 2 & 3) would reduce the value of their currency and promote inflation, now forecasted to be .2 percent in 2016 in Europe.

It’s a great idea, except the exact opposite happened – the Yen and the Euro both got stronger because the markets have lost faith in their central banks’ ability to solve macro-economic problems. When their currencies went up, ours went down, even though they now offer negative interest rates. This is the sort of thing that happens when man messes with nature.

Historically, the average market cap for the S&P 500 is 53 percent of our GDP; currently is at 99 percent. In other words, this metric is twice as expensive as its normal benchmark. Should we account for the global nature of corporate revenues, we would have to add the entire Japanese and Chinese economy to bring it into balance.

It’s not surprising that an immediate reaction to obvious economic indicators has yet to occur. Over the holidays I went to the movies with the family to see The Big Short, a movie that described how several hedge funds and high stakes investors recognized the housing bubble and bet against it. One gentleman did the math and saw the foreclosure landslide. Another went to a strip club and found out that the dancers owned four and five homes with adjustable rate mortgages. On and on it went, the evidence mounting that the light at the end of the tunnel was indeed a freight train.

graph22These investors ultimately generated huge returns for their investors, but they made these predictions in the middle of 2007 and spent close to a year on the hot seat. Warren Buffet can sympathize; he was chastised for not buying internet stocks as early as 1998. Reasonable people would have saved face, it’s easier that way, unless you’re convinced that the train tracks are a dangerous place to be.

This was the dilemma of investors who bet against the market at the beginning of 2016 with what’s known as a short sale. When investors want to bet on a stock falling, they typically sell shares that they’ve borrowed and then buy them back once the stock has dropped. If the market moves against them, they can get stuck covering their positions by buying back a more expensive stock, which can propel the market higher when it happens in large amounts.

The amount of shares that were short last month was the highest it’s been since 2010. That in and of itself is not important, except that when the market moves against institutional investors, they’re forced to close out short positions despite their long-term thesis. It turns out the hypochondriacs were everywhere, just waiting for the other boot to drop.

This dynamic, albeit irrelevant to a long-term outlook, produces artificial demand that manufactures short-term rallies. The lower dollar tipped over the first domino and the short squeeze kicked the rest of them down, similar to what we saw in the fall. Oddly enough, right now the short interest in the S&P 500 is the lowest it’s been since mid-December, right before the market dropped by 10 percent.

With all of that said, the things that would produce long term appreciation are in reverse. Consumer confidence is off its February 2015 peak and still deteriorating, durable goods orders are down 2.5 percent year over year, consumer spending has decelerating from 2.4 percent growth to 1.9 percent growth, inflation continues to decline on a rate of change basis and GDP growth is now .05 percent, down from 1.4 percent in the 4th quarter.

There simply is no obvious place to hang your hat on the idea of an economic expansion. Stock buybacks and another round of Quantitative Easing may come to the rescue, although buybacks just hit a 21 month low and more funny money might be considered a sign of weakness. To paraphrase the late great 18th century Samuel Johnson, arguing against the data is the last refuge of a scoundrel.

In instances like these, innovation and creative destruction saves the day, with new market participants forcing the old guard to get their groove back. Small-company creation in America, however, is at the lowest rate since the 1970’s. When 29 percent of professions require permits up from five percent in the 1950’s, it is equivalent to a digging the moat around incumbents just a little bit deeper, making it a little more difficult to cross. As a consequence, a profitable company has an 80 percent chance of being that way ten years later, up from 50 percent in the 1990’s.

All of this has manifested itself in a presidential campaign for the ages. Our founding fathers did not establish a democracy that gave power to the popular vote in fear of mob rule. Instead we live in a republic that relies on an Electoral College run by delegates to serve as a firewall to prevent “democratic wildfires”.

Donald Trump and Bernie Sanders believe, among other things, that corporate interests and well-funded party insiders bought the system outright and told the mob to pound sand. The mob agrees with the protagonists that waterfront property isn’t everything it’s all cracked up to be.

The truth is the money spent on lobbying has risen by a third in the past decade to $3 billion. Meanwhile, a mastery of patent rules has created barriers to entry in health care and technology, America’s two most profitable industries. New regulations don’t really keep big banks under control, instead they keep competitors out, which is in part why the banks have gotten even bigger. The game is certainly rigged, just not the way you would have imagined.

It’s not that we’re headed back to another 2008, it’s that the response to 2008 was to protect financial assets against the impact of normal business cycles with monetary policy and stock buybacks. And maybe this is the new reality, that central planning makes public companies immune from the capital market ecosystem, but I tend to doubt it.

The pendulum will swing back at some point on all of these matters, the republic is in no imminent danger, but I’m not inclined to chase this rally or the ones that may follow. Outside of another Federal Reserve stimulus package or another surge of buybacks, the data points do not suggest a sustained expansion to warrant stocks trading at these levels. After all, if GDP contraction doesn’t matter, what would be the point of having an economic policy in the first place?

A man who visited my father’s now closed liquor store would opine frequently that “you gotta go for what you know”, and because he patronized the store more often that he should have, I never quite took him serious. Maybe his message got trapped in a bottle, maybe he was trying to a save somebody else’s life having been unsuccessful in preserving his own. Maybe he had a point.

Our founding fathers, flawed as they were, demanded that reason prevail over the emotional impulses of the mob. This presents the ultimate question: if the unprecedented level of stock buybacks and financial engineering over the past five years did not jerry-rig the numbers and there really is an economic expansion that justifies markets reaching higher highs, great, count me in, just show me the numbers before I drink any more wine.

Securities offered through LPL Financial, Member FINRA/SIPC (http://brokercheck.finra.org/). Investment advice offered through Delancey Wealth Management, LLC, A registered investment advisor and separate entity from LPL Financial.

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly.

The opinions expressed in this material do not necessarily reflect the views of LPL Financial.

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly.

The opinions expressed in this material do not necessarily reflect the views of LPL Financial.

1 Foreclosure Gridlock Threatens Economy; nbcnews.com; 12/3/07
2 U.S. Corporate Profits on Pace for Third Straight Decline; Wall Street Journal; 4/28/16
3 Brussels Downgrades Forecasts for Eurozone Inflation; Financial Times; 3/3/16
4 By this measure, the S&P 500 is overvalued by 72%, CNBC.com; 4/18/16
5 Traders haven’t bet against stocks this aggressively since 2010; Business Insider; 5/4/16
6 Consumer confidence hits 94.2 in April, versus 96 estimate; CNBC.com; 4/26/16
7 U.S. economy grows at slowest pace in two years; Los Angeles Times; 4/28/16
8 US advance Q1 GDP up 0.5% vs. 0.7% expected; CNBC.com; 4/26/16
9 What you need to know about the slowdown in buybacks; CNBC.com; 4/18/16
10 The problem with profits, Barron’s Magazine; 3/26/16
11 Democracies end when they are too democratic; Andrew Sullivan/New York Magazine; 5/1/16