Zeller Kern’s Investment Monitor

As The World Turns, Markets Remain Positive

July 12, 2017

By Steve Zeller

As President Trump travels abroad attending the G20, meeting Putin, and as the dictator continues on in North Korea, the U.S. equity markets remain in a positive trend, overall. Year-to-date as of the market close last Friday, the Dow Jones industrial Average is up 9.77%(including the reinvestment of dividends), the S&P 500 is up 9.49%, the Russell 2000 Small Cap Index is up 5.04%, and the NASDAQ is up 14.30%, which is the index that reflects the current Tech stock frenzy underway.

As far as we currently see it, we still expect further new highs to be realized, even though it would not be surprising if we have a temporary pullback, before resuming an uptrend. What kind of pullback is possible? Well, a 1,000-point decline of the Dow from the highs achieved in June is possible, bringing the Dow down to the 20,500 level before resuming an upward trend. We realize that many folks out there are already calling a top in this market, but we remain convinced that this isn’t so. The animal spirits of the investor still remain strong, and if there is any kind of tax reform or healthcare reform out of Washington, events like this, could fuel the frenzy even further, sending the market to new highs.

On the other side of things, as we have mentioned in our previous issues, we also recognize that this current bull market cycle (a period of rising stock prices, overall) is over 8 years in length, equity valuations are very high, from a historical perspective, a few stocks are responsible for most of the gains, thanks to the FAANG stocks, margin debt is at new all-time highs, and the longer term risk of a major disruption within the financial markets remains intact, which is the debt levels worldwide.

So far, the real cracks that are appearing within the debt machine, here in the U.S., is municipal debt, even though the strength in the market for municipal bonds remains strong overall. In other words, optimism towards municipal bonds remains very high, even though the financial conditions for state and local municipalities are deteriorating, mainly because of the crushing increase in pension liabilities. When you apply the math, something will have to give – either states and cities will choose to face the music and institute major reforms, or tje risk of bankruptcies will begin to mount, in our opinion.

The challenge with the Muni bond market, for investors, is that retail investors are particularly at risk because of the lack of pricing transparency, meaning, there isn’t any muni exchange where ongoing bid/ask spreads are regularly and openly displayed. This is a condition of caution for investors, in our view.

The situation in the State of Illinois is accelerating into a crisis and has become a basket case. Illinois has been operating without a budget for over three years, and has piled up $15 billion in unpaid bills. Furthermore, Illinois is in the worst pension crisis in the nation and needs immediate reform before it is sent into “Junk” bond status. Currently, it is reported that the state has approximately $251 billion in unfunded pension liabilities. Some argue that it is impossible for a state to go bankrupt and that pensions are a constitutional right. That may be the laws, currently, but the state constitutions don’t say how much pension, starting at what age and for how long. Additionally, as we have mentioned before, when you're broke you're broke. Nobody will lend money until a state restructures itself. In the meantime, life becomes very difficult, with Puerto Rico being an example.

This situation is not isolated to Illinois. Other states that are hopping onto the watch list include Connecticut, New Jersey, and California. The longer these states such as California remain in denial, mainly for political reasons, the worse it gets and the more drastic the required remedy becomes. Some states, however, such as Pennsylvania, have recently passed bipartisan legislation to try and fix the problems. In June, Governor, Tom Wolf (D), signed into law, which was approved by the Republican legislature, moves new government workers, starting in 2019, from the existing and unsustainable pension plan, to one of a hybrid plan that includes a 401k component. But the state still is stuck with a $70 billion pension shortfall, and this recent legislation does not solve that dire problem. To date, we haven’t seen any state address the problem with any kind of meaningful reform, which adds to future risks.

As we all know, things don’t remain the same, and changes are always occurring. But what changes are ahead remains to be seen. Will it be proactive reform, or forced reform? One way or another, reform is coming.

The condition of debt seems to be the norm within many areas of our lives. Federal debt, municipal debt, corporate debt, student debt, auto loans, mortgages, etc., seems to continue to pile up and not faze anybody. It’s becoming common to hear of the younger population, taking on $100,000 in individual debt to put themselves through college, and perhaps not bothering to consider the harm it may cause in the long run.

As reported in Forbes earlier this year, Student loan debt is now the second highest consumer debt category, behind only mortgage debt, and higher than both credit cards and auto loans. Student loan debt has now piled up north of $1.3 trillion; the average student in the class of 2016 holds $37,172 in student loan debt. I recently rode in a Lyft ride with a young millennial back in Boston, and she told me that her rent was $1,500 per month and her monthly student loan payment is $1,000, and she is making around $50,000 a year salary. No wonder why fewer of the young folks aren’t driving, especially in cities such as Boston. But many are duped into borrowing, or spending, astronomical amounts for an undergraduate degree.

At any rate, here are the stats as of the February 17th, 2017, article in Forbes magazine (source: New York Federal Reserve, 4th quarter 2016): Total Student loan debt - $1.31 trillion; Total U.S. borrowers with student loan debt – 44.2 million; student loan delinquency or default rate – 11.2%; Total increase in student loan debt in the 4th quarter of 2016 - $31 billion; New delinquent balances (30 days) - $32 billion; New delinquency balances – seriously delinquent (90+ days) - $31 billion.

As we look forward to this coming week, it looks to be yet another slower summer week from a news standpoint. The only notable event, really, will be on Wednesday when Janet Yellen is testifying to Congress. Other than that, we are seeing very little news coming out. On Thursday, the Jobless Claims report will be released. Friday is the biggest day with CPI, Retail Sales, Consumer Sentiment and Business Inventories. However, none of those should be impactful to market sentiment.

Looking back on last week

The market started off on a very flat note with Monday showing a slight positive with the S&P finishing up 0.23%, closing early on the session. As you would expect, trading volume was very light as market participants took advantage of what would be a five-day weekend.

The markets were closed on Tuesday but the S&P was able to add another 0.15% on Wednesday as the markets continued to ignore the declines that were occurring in the NASDAQ.
Thursday was the big day as the markets declined sharply. There was finally some contagion from the NASDAQ as the selling bled over into other markets.

On Friday, the market had the employment situation come out and a continued positive outlook has kept an underlying bid in the markets as we saw the NASDAQ and the S&P reverse off major support levels that were tested on Thursday.

In the end, the S&P was able to close up 0.7% for the week. But the big back story was once again the decline in crude oil as it dropped 4.1%. This followed the news that the OPEC production increased in the month of June and that Russia was not in favor of deepening current OPEC led production cuts.

The employment situation showed 222,000 new jobs and the unemployment rate back to 4.5%. This was enough to improve sentiment for the markets as they all moved higher with S&P up 0.64% on the session.

Friday’s action had a sharp rebound off of the key support levels that the S&P tested on Thursday at 2408 to close higher at 2425.18. There were several key numbers on the S&P that needed to hold. The most critical one was 2408.40. The second one was 2424.40 which the market managed to just close above.

This combined along with the NASDAQ closing at 6153, well above its critical level at 6087, sets the tone for a stable week ahead.

There appears to be very little from a technical standpoint to move the markets either way as short-term market momentum is flat. The intermediate trend remains in a slight bullish tone as is the longer-term indices, but there’s very little here that is likely to drive the market sharply higher.

There are some key numbers above the market. A close above 2441.75 on the S&P 500 will indicate higher prices toward 2450/2458. The declines that we saw last week managed to hold support and not negate the upward objective so we are still looking for a move towards the 2489/2507 levels.

It seems that the markets continue to stretch to the extreme and then bounce off of those levels to remain in this choppy sideways pattern. Other than the Dow Jones which been able to squeak out a new high here and there, the S&P and the NASDAQ continue to trade in this sideways, choppy range and the patterns do not suggest that we are going to get out of this anytime soon.


*Last week’s market recap provided by VPM Partners

Best Wishes,

Zeller Kern Investment Committee