Winter 2016 – Newsletter

Never let the other fellow set the agenda – James Baker, Former White House Chief of Staff

I was never a great athlete. Sure, I played football, baseball and ran track in high school, but I batted 7th and ran third leg in the relays. I fared a little better at tennis, having signed up for a class in college where I learned about a place on the court called “no man’s land”, which is the area above the baseline and behind the service line.

If you think about where players are taught to hit a tennis ball during a volley, it lands in “no man’s land”, and any opponent standing there would have a difficult time hitting the ball from their toes over the net. Players who occupy this region are caught in between two convictions, smack dab in the middle of playing aggressively at the net or pursuing a more defensive strategy behind the baseline.

I wrote an article for Ebony magazine in November of 2007 where I stated that “the mere thought that our bond market is exposed to the credit risk of homeowners has gone largely unnoticed” because I knew a market crisis is caused by an event, not an economic condition. So how does one react to that? Who wants to be bearish in a rising market? Who wants clients to lose money because they’re afraid of being defensive, explaining their actions to trigger happy regulators and opportunistic lawyers?

diagram4The crisis of 2008 was predictable to anyone paying attention, and although everyone was affected, some mitigated their downside exposure more than others. In the aftermath of the last recession, the financial markets have essentially been financially engineered with quantitative easing and stock buybacks. As you can imagine, it is very difficult to find conviction in a game of digital musical chairs, particularly if you believe somebody keeps adding places for everyone to sit and nobody knows when that person will leave the room.

graph23Keep in mind that stock prices are predicated on earnings per share, which is calculated by Net Income minus Preferred Dividends divided by Number of Outstanding Shares (please note that preferred stocks and their dividends are a fraction of the overall equity market). As you can tell from the chart, publicly traded companies have spent more than 100 percent of their net income on common stock dividends and stock buybacks since 2014. Dividends make companies more attractive to investors, while buybacks, the vast majority of this scheme, have a much bigger impact.

graph24When a company purchases its own shares, the denominator (shares outstanding) becomes smaller. Once the denominator declines, net income remaining constant, the earnings per share is artificially amplified, leading to a higher stock price. The question investors must now ask themselves is how long can companies continue to gerrymander earnings per share calculations?

Many analysts will report outcomes on an absolute basis, but a more accurate approach would be to digest results on a rate of change basis. If a metric increases from 10 to 12 and then 12 to 14, it is still growing, but it is decelerating, going from great to good which is bad. In that same vein, earnings per share on a rate of change basis has declined, having already benefited from stock buybacks that cannot increase in volume since companies already spend more than 100 percent of what they make.

graph25This is the first of many breadcrumbs that might help us connect the dots. A capital expenditure, which declined every quarter in 2015, is an outlay of cash used to acquire or upgrade a business asset. When companies spend all of their money paying dividends and buying their own shares back to manufacture earnings, at some point it shows up in profits. Imagine washing your car without ever changing the oil.

graph26What you’ll notice in the illustration is that any time corporate profits have declined two quarters in a row the S&P 500 has dropped by 20 percent from its peak. It turns out that companies who do not reinvest in their business sacrifice future gains for current earnings. It makes perfect sense since the compensation package of senior executives is based on the performance of the company’s stock. A funny thing happened on the way to the victory parade – corporate insiders have been dumping shares at the highest pace in 4½ years.

Despite evidence of a slowdown, the Fed raised interest rates. This is par for the course: the United States has had 20 recessions in 100 years and the Fed didn’t predict a single one. When rates go up, the dollar increases in value and causes deflation. This is reflected in the Producer Price Index (PPI), which is declining on a rate of change basis. When companies cannot increase their prices, they don’t need as many workers. Unemployment figures, therefore, are a lagging indicator – they’re the last piece of good news before a recession.

On the other hand, a lot of news seems to be coming from the presidential campaign trail. With all due respect to our two party political system, we’re essentially playing kick ball with one leg – no two organizations can be this bad unless they’re working together. It would be impossible. What I do believe to be true is that the wrong guy always seems to take the blame and the presidents who come out smelling like a rose have usually screwed things up. Whether that’s Bill Clinton deregulating Wall Street or Ronald Reagan increasing the national debt by 60% as a percent of GDP, there is an identifiable pattern of framing somewhat innocent men.

graph27Take Jimmy Carter for instance, the poster child for inflation and disastrous economic policies, even though inflation started increasing in 1965 and he cut the capital gains tax from 39% to 28%. What is seldom mentioned is that he deregulated the airline, trucking and railroad industries that reduced transportation costs, and did so at the expense of unions who supported Ronald Reagan in the 1980 election. Inflation didn’t just go down in the 80’s because Paul Volcker raised interest rates (who for what it’s worth was appointed by Jimmy Carter), but a result of dramatic declines in transportation costs in the wake of deregulation.

If you still think there are two separate parties, you’ll notice that neither Jimmy Carter nor the Democrats defended Jimmy Carter. Meanwhile, the Republicans didn’t once mention the Commodities and Futures Modernization Act of 2000 that deregulated derivatives in any of the 2008 presidential debates when they were thrown under the bus for Wall Street’s antics. How much debate prep do you need to say “a Democrat signed the legislation”?

This same dynamic will be manifested when the economic slowdown impacts the markets as a villain will emerge. My money is on the Federal Reserve as this year’s boogeyman. Wall Street will always find a reason to be long stocks because they search for data points that support their marketing efforts and revenue agenda. There has to be a reasonable explanation for why they were wrong.

graph28This leads to the elephant on the floor of the New York Stock Exchange: are we headed towards a recession? Well, which market? Which industry? The ISM Manufacturing Index monitors employment, production inventories, new orders and supplier deliveries.

An ISM of more than 50 represents expansion in the manufacturing sector, a reading under 50 represents a contraction, while a reading at 50 indicates no change. As you can see, on a rate of change basis, it is in steep decline. Even if you drill down to capital goods ordered, again, simply on a rate of change basis, this sector of the economy is already receding.

graph29This comes at a time when oil, nickel, wheat, iron ore, aluminum, Germany, Italy, Spain, Japan, China, Emerging Markets and the Russell 2000 have already dropped by 20 percent from their peak. There is a silver lining: the sale of previously owned homes climbed to a 5.49 million annualized rate, the strongest since February 2007. The only problem is homeownership rate is at its lowest point in three decades, an indication that large investors are propping up the market. It’s one gimmick after another.

The Federal Reserve reported that the US economy grew at an annualized rate of 0.7 percent in the fourth quarter of 2015 on January 29th compared with the same quarter a year ago when they reported 2 percent growth. Despite the negative news, the S&P 500 shot up by 2.4 percent because Japan implemented negative interest rates in an effort to reduce the value of their currency and increase exports.

I am not bullish or bearish, I just looked at the data points on a rate of change basis and came to the conclusion that we have reached an inflexion point. And yes, the markets will have days, weeks or months when they bounce off of their lows, but as I stated in my last newsletter, I’m not chasing these rallies.

As a consequence we have much more cash than usual and own positions intent on managing volatility. I doubt we’ll see Chicken Little being interviewed on CNBC any time soon, but I do know the numbers don’t add up. This is not an easy call to make because I understand the consequences of being wrong.

If I found a single credible source to suggest the presence of a legitimate economic expansion, my thesis would be different. So I’ll keep looking, but until then, we’re going to stay away from “no man’s land” and remain defensive.

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 How the Mortgage Crisis is Affecting You; Ebony Magazine; November 2007
2 Special Report: Surging U.S. stock buybacks dwarf innovation spending; Reuters; 11/16/2007
3 More buybacks, less capex in 2016: Goldman; CNBC; 11/9/2015
4 Insiders sending an ominous market signal; CNBC; 11/23/2016
5 The Homeownership Rate Is Near a 30-Year Low. Could It Be Hitting Bottom?; Wall Street Journal; 10/27/2015 6 US economic growth slows sharply; BBC News; 1/29/2016
7 Stocks Soar After Bank of Japan’s Surprise Rate Move; Wall Street Journal; 1/29/2016