Summer 2015 – Newsletter

I don’t care half so much about making money as I do about making my point, and coming out ahead – Cornelius VanderbiltWhen I was a kid we used to ride our bikes in the middle of the street because people would hide in between parked cars and close line us as we rode by to steal our ten speed contraptions. It was ingenious, although they should have just gone to grad school – we only lived a mile away from Wall Street.

I miss the Lower East Side. We had red boxes on brick walls to represent the strike zone in stick ball contests, petty thieves, nosy neighbors and bankers all wrapped up into housing projects, Coop apartments and the historic tenements where the immigrants began their new lives after they left Ellis Island. Given its proximity to the financial district, the neighborhood has since been gentrified, made anonymous, sanitized. Something must be in the water.

If you’ll recall, small businesses gave neighborhood kids their first jobs with interviews conducted from storefront windows and church pews, the owners always noticing who helped their best friend’s grandmother carry groceries across the street. Years later there are legions of financially disabled children marching through the malls, handicapped by a lack of work ethic, their after school jobs replaced by video games and music lessons.

graph13Walks down memory lane aren’t meant to be prosperous, but this country has found itself at the crossroads of outsourced jobs and job creators, Main Street versus Wall Street and economies of scale digesting local economies. Somewhere along the way consumers decided that lower prices and big box super stores made the world go ‘round, lured by elaborate product placement ads and loss leaders.

Much has been said about the demise of middle class, and quite surprisingly, some of it is actually true. The Bureau of Labor Statistics recently reported that the unemployment rate was 5.5 percent. It is not unlike the contractor who gives you an estimate, knowing full well the price will rise once he sees what’s behind the wall. And as we all know, there is always something behind the wall.

What he’ll find is something known as the U6 numbers that represent the folks working fewer hours than they’d prefer, or having run out of unemployment insurance, are presumed to have quit looking for a job and no longer count as being unemployed. And when 10.8 percent of Americans are unemployed or underemployed, that’s a lot of people not paying taxes or buying things. Right now, the labor participation rate is 62.9 percent, the lowest it’s been in over 35 years.

There’s also a matter of father time and his dry sense of humor. Population growth causes inflation when more money is being spent. The 65+ year olds as a percent of working age populations in the U.S. on a rate of change basis has doubled in five years and the same can be said for Europe, which suggests these numbers are accelerating. China’s aging population rate of change is expected to double twice in the next 20 years.

graph14The consumer price index (CPI) on a rate of change basis has correspondingly decelerated and it’s even more pronounced in Europe, struggling with a 0.9% inflation rate that signals weak growth. China’s growth has tailed off as well, growing at 7 percent as compared to 12 percent just five years ago. Sure, you can blame lower oil prices on increasing supply, but it doesn’t explain lower milk, rubber and iron ore prices dropping at the same time.

When wage growth is flat and consumers spend less money, businesses cannot raise prices. This is known as deflation, and if a company cannot increase what they charge for a widget they’ll likely manufacture fewer widgets, and once that happens, everyone loses.

To combat these dynamics, the European Central Bank has followed the Federal Reserve’s lead and implemented its own €1.4 trillion Quantitative Easing program, using the Euro to buy European bonds and provide liquidity to the economy. When the ECB intentionally reduces the value of the Euro to increase exports and stimulate growth, the dollar increases in value. This has the opposite effect of a falling dollar, where you would need more dollars to buy the same loaf of bread, better known as inflation.

Should the Federal Reserve raise interest rates, the dollar would appreciate, it becomes more expensive for consumers to borrow money, deflation would accelerate and we’d be in all sorts of trouble. If you’re wondering why the Fed hasn’t raised interest rates yet, that’s why. Because they can’t (and shouldn’t). Not now any way.

graph15In this circumstance we want to own industries that get paid in U.S. dollars and can still raise their prices. Included in this list has been mid cap stocks, healthcare companies, REITs, utilities and international equities that would benefit from quantitative easing in Europe. Nobody asks for ice cream at the Good Humor truck, they buy a particular flavor.

The S&P 500 is the ice cream, not a flavor, although the underlying companies do have something in common: they use 95 percent of their earnings to buy their own stock. Let that sink in for a moment. This practice has served to increase demand for shares of stock whose supplies are correspondingly being reduced. We’re talking $2 trillion since 2009 of manufactured demand. That’s why we also own a stock buyback ETF that owns companies artificially increasing their own share price.

There are indeed a lot of moving parts and the people moving them have always been incredibly interesting characters. In the 1860’s Cornelius Vanderbilt, at the time one of the wealthiest men in the country, wanted to buy Erie Railroad. Unfortunately for Vanderbilt, Daniel Drew was the treasurer of Erie Railroad who had already made a fortune manipulating the stock and gained control of the company by lending it money in exchange for shares of the railroad.

Please note that all of this happened before regulations were imposed on financial transactions. They didn’t even have to pretend. As Vanderbilt bought shares of Erie Railroad and ran up the price, Daniel Drew cashed in his stock for a profit, then sold the same shares short, made money when they dropped and pulled the rug out on Vanderbilt. Oh, and he was just getting started.

After being ousted by Vanderbilt’s friends on the board who were on the take, Drew weaseled his way back into the company, hooked up with two other characters (James Fisk and Jay Gould) that printed shares of the company (as in a printing company arbitrarily reproduced the shares) and dumped them in the market as Vanderbilt tried to buy all of the available shares. They literally made money making quicksand on the floor of the New York Stock Exchange and they all got away with it.

Lo and behold, the large banks just got busted rigging interest rates and foreign currency exchange rates by the justice department, and in the process the companies caught felonies. Of course, just like in 1860’s, nobody is going to jail. No walk down to HR after the background check came back when you get your new job. It’s just business as usual.

To show you how good the banks have it (and I really do admire their ability to commit crimes without recourse. It sure beats stealing bicycles from ten year old kids), they signed a deal with the SEC that essentially said they could sell securities to the public with no consequences if they did the exact same thing again.

So much for sticks and carrots; the regulators have signed away the nuclear option. From here on out its all expressions of outrage on Sunday talk shows 20 second soundbites at a time and fines that are a fraction of profits. There will, however, be no perp walks or cease and desist orders. This revolution will not be televised.

I suppose this is to be expected. The best and brightest used to become judges, engineers or run for political office. At some point they realized they were smarter than everyone else, plus there’s no money in it. Now they work on Wall Street. Why fight city hall when you can buy it? Why cop a plea when you manage the money for the pensions the cops still think they’re getting, cause guess what, state pensions are underfunded by $4.1 trillion.

The moral of the story is that the banks, if you recall, made $6 of every $1,000 of mortgage backed securities they sold, while also betting that these same bonds would lose value. Global losses from the housing crisis amounted to $15 trillion, the global economy almost collapsed and the banks that were too big to fail got a lot bigger.

What, I dare ask, would happen if S&P 500 companies buy fewer shares of their own stock? Better yet, how can they increase future profits when they’re spending less money on research and development, human capital, equipment and all the sorts of things that increase growth?

graph16As it stands now, year over year revenue and earnings per share growth are decelerating and expected to be negative this year. Rising interest rates are a concern, but they teach supply and demand the first day of Econ 101 for a reason. And given their history, why wouldn’t banks profit when stock buybacks dry up?

What I just described isn’t just a Ponzi scheme, it’s completely legal. It’s not the end of the world, we survived the last two crises, but it’s worth noting and preparing for what appears to be a game of digital musical chairs. The 2008 crisis was easy to predict, it’s just that nobody knew when it would happen, and the more things change the more they stay the same.

Hope is not a risk management process. In that sense, we own positions that lose every horse race except one – when a market crisis is chasing you. Close to 20 percent of the accounts, depending on the allocation, are in hedges. The idea is that the industries positioned for the current economic environment will provide enough appreciation to accommodate the drag of this party’s chaperone. When the atmosphere changes, which could be closer than we think, so too will the portfolio.

So far so good in 2015, despite the short countertrend in April when the Greek debt issue pushed interest rates higher. In fact, job openings are the highest they’ve been since 2000 and U.S. small business confidence is at a five month high. The slow growth situation can evolve at the speed of some government report into an inflationary environment and the trick is not chasing your own tail, confusing headlines with long term macro-economic trends.
I live in Washington, DC these days in a neighborhood that’s been rejuvenated. For those paying close attention, I just spruced up the word gentrification, added some hardwood floors and flipped it to a young couple moving to the city for the first time. You have to admit it sounds better.

Of course, the displaced people have to go somewhere and you can’t gentrify an entire global economy. All you can do is plan accordingly, pay very close attention and play with the cards you dealt yourself. After all, the American dream is free, but the hustle? Well, that’s sold separate.

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

Quantitative Easing is a government monetary policy occasionally used to increase the money supply by buying government securities or other securities from the market. Quantitative easing increases the money supply by flooding financial institutions with capital in an effort to promote increased lending and liquidity.
International investing involves special risks such as currency fluctuation and political instability and may not be suitable for all investors.

The Standard & Poor’s 500 Index is a capitalization weighted index of 500 stocks designed to measure performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries.

The Dow Jones Industrial Average is comprised of 30 stocks that are major factors in their industries and widely held by individuals and institutional investors.

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 Nonfarm payrolls total 280,000; unemployment rate at 5.5%; CNBC; 6/5/15 2 Chart: What’s the real unemployment rate?; 2/6/15
3 The May Jobs Report in 12 Charts; Wall Street Journal; 6/5/15
4 Inflation Returned to Eurozone in May; Wall Street Journal; 6/2/15
5 China’s G.D.P. Slows to 7 Percent, the Weakest Rate Since 2009 6 Simon Dawson/Bloomberg
Here’s What Economists Think About the ECB’s Historic Stimulus Plan; Bloomberg; 3/16/15
7 S&P 500 Companies Spend Almost All Profits on Buybacks; Bloomberg; 10/6/14
8 American Companies Are in Love With Themselves; 3/15/15
9 Six Banks Pay $5.8 Billion, Five Guilty of Market Rigging; 5/20/15
10 There’s only one thing keeping 5 of the world’s biggest Wall Street banks in business; Business Insider; 5/21/15 11 Bad News For State Public Pension Plans; Forbes; 11/20/14
12 Total Global Losses From Financial Crisis: $15 Trillion; Wall Street Journal; 10/1/12 13 Too big to fail banks just keep getting bigger; CNBC; 3/5/15
14 US job openings tick up in April; CNBC; 6/9/15
15 US small business confidence rises to five-month high; CNBC; 6/9/15