Trends vs. Logic

Data or Demand?

In case you haven’t noticed it yet, there’s a serious election going on right now.  Votes are being cast day after day, and the message seems pretty clear: buying American stocks, bonds, and real estate is how investors are voting with their money.  We very well could be looking at the fifth consecutive quarter of corporate earnings growth declines for the largest companies here in the U.S., and that’s something that has not occurred since…when was it?  Oh right, it was the 5th consecutive quarter period from Q3 2008 through Q3 2009.  Remember 2008?  But today’s stock market environment couldn’t be more different than the way things were in 2008.  Let’s first look at some of the important data that’s coming in, and then we’ll step back and look at the forces driving these markets higher.

Earnings and Economic Data

Second quarter earnings growth are currently expected to decline by -3.7%, and quarterly earnings conference calls are offering some clues about lasting “Brexit” concerns.  Many CEOs and CFOs are again repeating concerns over how currency fluctuations are impacting earnings.  The U.S. dollar has been working through a strengthening cycle for the last several years, and while the first half of 2016 showed some signs of a reversal in the USD’s strength, the Brexit vote caused the USD to appreciate again versus the British pound, the Euro, and the Yen.  Remember, a strong USD can be a headwind to U.S. multi-national companies that make money overseas when they have to convert those earnings back into more expensive U.S. dollars.  This currency conversion impacts a lot of S&P 500 companies but tends to affect mid-size and smaller-size companies less due to their more domestic footprint.  This could be supportive for mid-cap and small-cap stocks, although they tend to be riskier and more volatile.US dollar

Early in July, we saw a very positive jobs report, in which the unemployment rate fell to 4.9%.  We also got positive reports about existing home sales mid-month, and the U.S. Purchasing Managers Index (PMI) dropped a bit, but only down to 50.9 (generally, any reading over 50 is positive as it indicates expansion).  Additionally, housing starts jumped almost 5% in June, which shows continued improvement in housing overall.  However, other economic data has not been so positive.  The first estimate of U.S. Q2 GDP came in at a disappointing 1.2% annualized, and forecasts for much of the rest of the world have fallen.  Some analysts have commented that the figure for U.S. GDP—when put in context of the unemployment situation—suggests that the economy’s potential growth rate could conceivably be near zero.  Ouch.  PMIs for Europe, Japan, and China have all declined, and the Brexit vote has led many analysts and economists to revise their forecasts for the U.K. to a probable recession.  Venezuela is in total collapse, and most of the countries who rely on exporting oil and other commodities are really suffering.

A Reversal in Rig Count

In short, the data coming from the oil industry doesn’t look good.  Exxon—generally looked at as the largest and highest quality integrated oil company—reported misses on both earnings and revenues.  Chevron, the close second to Exxon, missed on earnings but beat revenue estimates.  The sector, on the whole, is lagging all other S&P 500 sectors.

oil rig count

Rig counts are rising, and that’s not good news for the price of oil.  High rig counts mean more oil production, and this continued increase in supply will prolong the oil glut.  July’s final Baker-Hughes rig count report showed that the number of producing rigs has increased for five weeks in a row now.  Oil price spikes into the high-$40s per barrel range appears to be enticing domestic producers back to operations, and Middle Eastern producers are also showing no signs of curtailing production.  In fact, Middle Eastern production now makes up 34% of global output, pumping 31M barrels per day – its highest output percentage since the Arab fuel embargo of the 1970s when output from there hit 36% of global production.  Production shows no signs of slowing, and somewhat soft summer fuel demand has contributed to increases in storage.  High supply, softer demand, and renewed dollar strength are all contributing to the recent retreat in oil prices.  This is not a great sign for already suffering oil producers, but at this point, they’re reaping what they’ve sown.

The Birds at the Fed

You may have noticed how different Federal Reserve officials are often referred to as “Doves” or “Hawks.”  The Doves are proponents of easy monetary policy, with their goal being to stimulate the economy.  The Hawks are for tighter monetary policy, with their goal being to make sure inflation is kept in check and to keep the economy from over-heating.  Overall, Fed policy since the Great Recession has been very dovish, but recent, healthier economic data has led some Fed officials to take on a more hawkish stance.  The logic is that healthy unemployment and inflation data warrants policies to wean the economy off of quantitative easing, lower bank reserves, and low-interest rates.  Some of the Fed’s central bankers have been quite vocal about raising rates and letting the economy get back to normal, but month after month the official statements coming out of the Fed tell the story of more patience and procrastination when it comes to raising rates, in light of weak global growth.  It seems like this is their new tactic.  Some of the Fed presidents make news headlines with quotes about rate hikes coming soon.  Then, fast forward to the next meeting, and the tone is altogether different.  The Fed statements and press conferences message improving data, but they seem to be in no haste to raise rates.

Many economists expect the U.S. central bank to diverge from the rest of the world in regards to monetary policy and to actually raise rates soon, but the Fed’s most recent statement just last week confirmed there would be no change in rates at this time.  The statement messaged the possibility of a September rate hike, but markets don’t appear to be betting on it.  A lot of other countries are struggling much more than the U.S., and for them, quantitative easing may be far from over.  “Super doves” in Japan and Europe—where interest rates have gone negative—are running out of options.  Japan is now even considering “helicopter money,” that is the outright transfer of money to consumers, with the hope that they’ll spend this newfound wealth which some think will help the local economy.  “Helicopter money” gets its name because one can envision money being dropped on the masses from the sky.  In any case, it’s a desperate measure.  It’s a controversial measure.  And it’s a real possibility in this world of fiscal experimentation.

fed rate

Ebbs and Flows

Some of these fiscal measures are difficult to grasp, both in concept and in terms of potential real life application.  But don’t worry, right now it’s hard for the logically thinking investor to know where to put his money.  While the average U.S. investor has a lot of cash sitting on the sidelines and has moved more assets to cash so far this year, the foreign investor has been pouring money into U.S. stocks, bonds, and real estate, which has driven up prices of these assets.

Why have we seen these record inflows coming from overseas?  Well, what would you rather buy: A 10-year U.S Treasury yielding 1.4% or the 10-year German Bund with a negative yield?  Or, U.S. real estate vs. Chinese real estate (Google Ghost Cities of China some time)?  Or European stocks vs. U.S. stocks?  It’s easy to see why foreign investors have answered with a clear bias favoring U.S. assets.  Additionally, institutional investors who are required to buy high-quality sovereign bonds are opting for U.S. Treasuries for good reason.  Wealthy Chinese investors are buying properties in the U.S. and Canada, sometimes sight unseen.  And traders all over the globe are trimming their allocations to international stocks in favor of owning U.S. stocks.  To be sure, the U.S. economy is by no means all rainbows and gold stars, but we’re viewed as the “safest” place to invest, the “best house in a bad neighborhood,” the “cleanest dirty shirt in the closet.”  Pick your metaphor.

10- yr yields

And that’s how stock valuations have gotten to where they are today.  Five consecutive quarters of falling earnings growth isn’t good, and in ’08-’09, investment values dropped a lot…in stocks, in bonds, and in real estate.   But in 2016, with a very similar earning growth trend in place, asset values have resiliently climbed and may advance more.  In fact, we could be at the onset of even larger inflows into U.S. assets, and that could certainly allow U.S. companies more time to get their earnings in order to justify these higher valuations.  And these inflows also support why investors continue to own bonds in spite of record low yields.  Bonds can do well in scary times, and they generally have a lot less downside than other risk assets.

Trend vs. Logic

Over the long term, investment results are typically driven by fundamentals, by quantifiable data, by logic.  Is Company XYZ profitable now and/or are they expected to be profitable in the future?  Is the Bond of Company XYZ worth buying, and am I going to get my regular interest payments on that bond, not to mention my original investment back when the bond matures?  In this environment, you might be tempted to ride the wave, and “go all in” on U.S. stocks, and that trade could work…at least for a little while.  Just remember: some trends go bad.  Remember the dot-com era, or the sub-prime mortgage lending fiasco?  Trends sometimes turn into bubbles, but bubbles always pop.

cumulative flows

Markets don’t always move up or down based on reason and logic, but we must always study the nature of trends and reversals.  We continue to believe that a prudent investment process and a disciplined approach remain the smartest way to manage assets and risk.