Zeller Kern’s Investment Monitor

The Investment World We Live In

September 12, 2017

By Steve Zeller

There are many significant stories in the news right now, with the aftermath of Hurricane Harvey in Texas, the awesome size and effects of Hurricane Irma, North Korea, whether or not we will get any tax cut of any real significance passed, and whether or not the economy will expand into next year. With that being said, the market continues to hang onto most of its gains, year to date, and seems to be in a sideways pattern rather than any kind of a bolt upward to new highs until Monday, September 11, 2017 when the S&P hit a new high. So, there doesn’t appear to be a downward correction underway at this time. Although, it wouldn’t surprise us if we experience a correction in the near future. It is realistic in our view, that we could have a market correction, one that is in the low double digits, and then recover to new highs before this eight and a half year bull market cycle is complete.

But that remains to be seen in that, despite the political discourse, the geo-political concerns, threats with North Korea, and questions or concerns over economic growth, the stock market has marched higher. We are in a cyclical bull market that began in March of 2009, and is now the longest bull market dating back to 1921. And what is peculiar is the market has climbed higher over the past year with extremely low volatility. What that does to investors is it develops the mindset that we are in a bullet proof market and they deflect any notion of risk. But this has been backed by a combination of an improving economic outlook and a pretty strong reporting of corporate earnings over the last few quarters.

Technically speaking, the market internals appear to remain favorable. Investor sentiment is strong enough that it is concerning in that margin debt, the debt that investors use against their investment accounts to buy more stocks, is at or near all-time highs.

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The level of margin debt and record low interest rates have fueled and prolonged the euphoria of this current bull market and elevates the hope this positive trending market will last forever. Regardless, there are longer term challenges that continue to plague the system. The central banks continue to battle the forces of deflation in the world, primarily caused by the extreme levels of debt and the application of technology within the industrial revolution and how goods and services are delivered to the marketplace. From Amazon, putting brick and mortar retailers into a no-win situation, to fracking and horizontal drilling creating severe deflation in the oil industry, to robotics in manufacturing, to the delivery of financial services, health care, and artificial intelligence, all have contributed to the deflationary forces.

Central banks around the world have been attempting, for years, to avoid or prevent the deflationary forces from bringing the whole thing down. It has resulted in the largest and craziest monetary experiment of all times, with the unfathomable level of asset purchases by the central banks and debt creation the world has ever seen, in order to prop up inflation. Even though the Fed has threatened that it will continue to raise short term rates and begin to unwind its balance sheet that is bloated with purchased assets, the balance sheet of the Fed still remains to have $4.4 trillion in assets and has remained at or above that level for the past three years.

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But the effects of this policy are in question when it comes to the individual investor and saver. The insanely low and artificially created low interest rates have pushed fixed income investors into the stock market and riskier fixed income investments to avoid losing purchasing power. Outside of bonds, savings accounts provide a minimal pulse of any kind of return.The central banks have purposely driven down interest rates so far and for so long, that now governments are dependent on these levels to finance their debt, and investors and savers have become more desperate for returns - not a very good situation.

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However, historically low interest rates has been great for the sector of the economy which contain companies that are in the business of acquiring other companies such as venture capital groups financing company “roll-ups”, which is a larger company purchasing another, typically a smaller company, and rolling it up under one operation. This activity has been fueled by historically cheap and easy money (money borrowed at historically low interest rates). This activity has stretched across several industries and has reached a mania level. But it has helped the seller of businesses, such as the exiting “Baby Boomer” business owner, because, to a certain extent and depending on the type and size of their company, it has created a source of demand within the market place to acquire them and allowed them to exit into retirement.

So far this year, the equity market returns aren’t anything to complain about especially the big upswings this year occurring within the large cap sector of the U.S. stock market. Currently, equity returns within the stock market, as represented by the major indexes remains fairly productive. According to Morningstar.com, as of the market close on Friday, the S&P 500 is up 11.67%, year to date, which is roughly where it was three or four weeks ago. The Dow Jones Industrials is up 12.29%, the NASDAQ, home of the FAANG stocks (Facebook, Apple, Amazon, Netflix, and Google), is up 18.15%, the Russell 2000 index is up 4.01%, and the MSCI EAFE International Index is up 18.49%, year to date. Clearly, the large cap growth technology stocks have been a big contributor for the gains within the U.S. equity markets. The direction of the equity markets is in question due to effects of the hurricanes on the economy  in many sectors, but positive for others. Nevertheless, the Fed intervening with additional liquidity could be a positive thing for equities, if that happens.

However, as we have discussed in the recent issues of the Investment Monitor, the metric for measuring how expensive the U.S. equities market is, the Shiller P/E ratio, is historically very high. Even with the favorable earnings season, the Shiller P/E level is close to where it was in 1929 and is above where it was at the peak in 2007.

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But looking outside of equities, particularly with the bond market, is where you will find a consistent lack luster performance, with minimal returns, even going back a few years. Sure, there are sectors within the bond market that have performed well, including the irrational high yield bond market and any long-term bond (bonds or bond funds with 20 -30 maturities) that have provided returns. But for those that do have bonds or bond funds with conservative and short term biases, have benefited little, relatively speaking. But the investor has to keep in mind that pursuing a bond allocation with a slant towards high yield corporate junk, and long term government bonds is a much riskier proposition, in our opinion. Clearly, it is an investment world that one gets rewarded with returns only if they venture way out into the risk curve.

Scanning the bond indexes in the Morningstar Index page of their website, we can see that as of last Fridays market close, The Morningstar U.S. Core Bond index was up 4.04%, while the U.S. Short Term Core Bond Index is up a paltry 2.63%, and that’s including the reinvestment of interest income. On the more conservative end, the U.S. Government Bond Index is up 3.64%, with the U.S. Short term Government Bond Index up only 1.30% for the year. 

In the short term and maybe over the next several months, we can see short and intermediate interest rates trend lower. It is possible that economic conditions may be challenged over the next several months and possibly even trigger the Federal Reserve to add liquidity to the system, due to the massive disruption of the Hurricane in Texas and now Florida, though it appears that Florida was spared from the potential disaster that “Irma” could have inflicted. In looking at the 10-year treasury, yields appear to have a downward trend with the possibility of rates declining down to the 1.46% level and potentially lower, even down to the 1% range in our opinion. In the short term, we could see yields for the 10-year decline to the 1.97/1.87% range. There is a suggestion that the catastrophic effects of these two hurricanes will impact GDP on the short and longer term. The Fed may need to make accommodations for financing and other aspects of the recovery of these affected areas.  In other words, the Fed may have to add liquidity into the system.

The next several weeks will be interesting. We will be watching the actions by both the federal government as well as the Federal Reserve as we are likely to see comments start to emerge behind these catastrophic events.

This week, equities appear to have some strength as the damage from Hurricane Irma is much less than expected. There still are several things in the horizon that can have a negative impact on stocks.

Looking back on last week

All of the major US indices ended lower last week with most of the focus on the lack of confidence and the feasibility of tax reform along with the hurricane heading for Florida. The NASDAQ led the retreat, dropping 1.2%, while the S&P finished with a loss of 0.6%.

Even though the equity markets were slightly lower last week, the S&P finished just 0.8% below its record close of 2480.91 as treasury yields continued to decline to new lows for the year. Treasuries finished at 2.06 basis the 10-year. This is the lowest level since last November.
Other safe haven assets like gold and the Japanese yen moved higher, jumping 1.6% and 2.3% respectively. Gold finished at a 13-month high at 1351.10 per ounce.

 Heavyweight names like Home Depot, Pfizer, Exxon Mobil prevented the market from a significant decline but there was weakness in the small-cap and in high beta sectors of the market. The small-caps continued to be the weakest of all asset classes as they are only up 3.1% YTD, far behind the S&P at 9.9%.

With last week’s holiday shortened week, we saw a fairly big decline relating to the North Korean situation on Monday but markets rebounded and went flat for the balance of the week with the S&P 500 finishing down 0.61% at 2461.43.

The configuration continues to see a lack of follow through on the upside as we continue to trade in the trading range between 2446/2471.

The key level on the upside is the 2472.40 level. A penetration and close above this level will set the tone for a move toward the 2483/2497 levels.

Depending on how the markets perceive the hurricane event in Florida and Texas, it will give us some forward-looking perspective on how the markets will unfold over the next several months.
It’s possible that the Fed will show up and add some liquidity to the markets. The Fed funds market is most likely going to be affected with a number of the major banks not doing business as usual as most of the folks in Florida drove up state and the banks are closed for multiple days. The Federal Reserve’s open market actions over the next couple weeks will be quite revealing and possibly signaling further declines in interest rates.

While the short-term momentum continues to be neutral, it’s once again the intermediate momentum that continues to suggest a bias to the upside. The next two weeks will be critical in determining whether this momentum will be maintained or not.
Longer-term momentum remains a positive as there has been little change in the projected trend for higher prices.

*Last week’s market recap provided by VPM Partners

Best Wishes,

Zeller Kern Investment Committee