Goldman Sachs is sticking with equities over credit and credit over treasuries. Global economic and earnings growth has synchronized. There are elevated risks which must be monitored and some dry powder is recommended to take advantage of any market pullback. Read full outlook here.
Interesting paper on IPO market from University of Florida professor Jay R. Ritter available here.
Read full article here.
Full article published on advisorperspectives.com available here.
Nice breakdown on the Dow's ytd performance here.
Interesting article on school spending / quality available here.
4. Saves time
5. Avoids dodgy financial advisors
Full story here.
"Severe droughts in the heart of America's breadbasket are now so bad that some farmers are choosing not to even try to bring their wheat to harvest."
Read full article here.
WSJ article on wage pressures found here.
1. You Apply for Social Security Benefits Too Early
2. You Fail to Take a More Conservative Investment Approach
3. You Spend the Way you Used To Spend
4. You Miscalculate Your Required Minimum Distributions
5. Not Taking Health Care Expenses into Account
Full article available here.
The DOL Fiduciary Rule still remains uncertain although part of the regulation went into effect earlier this month. Most of the debate about the DOL Fiduciary Rule is ridiculous. Who would be against a common sense rule that requires advisors put client interests first? Any advisor not doing this shouldn't be an advisor to begin with. From a client point of view, it is non-sensical to argue against the DOL Fiduciary Rule. Who wants an advisor putting commissions above the client? Would a doctor remain in business if he did not put his patients' interests above his own? The truth about the DOL fiduciary rule: it's long overdue and it should do more to protect investors. It only covers retirement accounts of individuals, not taxable or institutional accounts, and it should do more to protect investors from fees.
John C. Bogle, founder of both The Vanguard Group and the first index mutual fund, wrote on this topic in the Financial Analyst Journal. The article, titled "Balancing Professional Values and Business Values", can be accessed here. The article is written for financial professionals, but I think it is a valuable read for clients as well. It is tough to come up an argument against his points.
The argument against the DOL Fiduciary Rule is the required record keeping. Since client account records and information are already collected and stored by advisors, this argument doesn't hold much water. A more interesting question is how did we get to the current status quote of selling products to generate commissions rather than putting clients first? Why is anyone (accept brokers themselves) defending a commission-based relationship? A transaction based model has never been in the clients best interest, yet much of the financial advisory industry still works on commission. There seems to be a growing shift toward a percentage fee on AUM model which is a step in the right direction. The short answer to how we got here is 'profits'. Brokers make more money from transactions then from fees on AUM, and that is a real shame on the industry. Now the industry has to move away from the commission-based distribution model. This may hurt broker profits in the short-term, but it is clearly in the best interest of clients. The DOL Fiduciary Rule is long overdue and more is needed to straighten out the unnecessary conflicts built into the current advisor/client relationship. For example, 12b-1 fees are sales fees which some mutual funds pay to advisors who sell those funds to clients. Clients may not even be aware of these fees which they are paying to their advisor because they are buried in the mutual fund expense ratio. These 12b-1 fees should be done away with as well as mutual fund loads. Both are fees investors should not pay... it's just common sense.
In 2015, Geoff Colvin, Senior Editor at Large with Fortune Magazine, published Humans Are Underrated: What High Achievers Know That Brilliant Machines Never Will. The book describes a new economy and the displacement of human jobs by computer software. The most interesting parts of the book were about what skills will be highly valued in the future economy. Colvin emphasizes the human-to-human interactions of empathy, story-telling, and team-building as examples of skills not likely to be automated. Why are schools so focused on teaching kids STEM, science technology engineering and math, not empathy, story-telling, and team-building? The transition from the knowledge-based economy to the human-connections economy will allow workers to focus on human interactions and relationship building. The book is an interesting read, but the sweeping conclusions are a bit idealistic and utopian. When I first read it, I wanted to run out and become a therapist. I can empathize, I thought. But future jobs will likely require both knowledge in STEM and skills in human interaction. It's not one or the other, but rather a need for both. Colvin makes it sounds like empathy, story-telling, and team-building will get you the next fortune 500 CEO job. It's a combination of knowledge-skills and soft-skills. The engineer who can empathize and the lawyer who is a story-teller. Of course, we all want a doctor with a good bedside manner, that's not a new idea. Colvin concludes healing and diagnostic skills will be automated, and the only thing the doctor will be left to do is feel for you, but I think this is an over-simplification. He touches upon team-building and the value of colocation, and highlights the fact that women typically score higher in the soft-skills area. Colvin brings all these human qualities together to underscore the importance of human connections. The broad conclusion on how the economy will function in the future is a bit of a stretch in my opinion. But his argument is completely compelling. Are empathy, story-telling and team-building important? Yes, for sure, but is social worker pay going to jump above software engineer pay anytime soon? I doubt it. It's a thought-provoking, well-written book and worth a read.
You can read a review by Tyler Cowen at the Washington Post here. A short adaptation of the novel is printed here.
Martijn Cremers is a Professor of Finance at the Mendoza College of Business of the University of Notre Dame. He published a research article in the latest Financial Analysts Journal titled, "Active Share and the Three Pillars of Active Management: Skill, Conviction, and Opportunity." The paper, accessible here and here, includes some great research on Active Share, Active Fee, holding period, and market cap. I recommend it to anyone interested in academic research on investment management. Active Share was first introduced by Cremers and Petajisto (2009) as a percentage of a fund's portfolio that is different from the fund's benchmark. One of the primary conclusions of Cremers' research is active managers with low Active Share tend to consistently underperform.
Cremers did NOT found statistically significant evidence that high Active Share led to outperformance or underperformance (although it may be a good starting point in fund selection). He did find strong evidence that low Active Share led to underperformance. These active managers are sometimes called closet indexers because they charge an active management fee for an index-like portfolio. To boil it down, if you are going to invest with an active manager, look for an Active Share north of 70% or even 80%. Cremers also provides Active Share information on mutual funds free of charge via the website activeshare.info. If you would like help looking into this or more information, please contact me.
The Vanguard Europe ETF, $VGK, and the European developed markets may be setup to outperform the U.S. equity market after a decade of underperformance. There are various ways to analyze this trade, and I will walk through a simple thought process to understand the risk and potential return of an overweight Europe versus U.S. equity position. First, I would like to look into the sector breakdown of each region. Below are the sector weightings of $VGK and $VTI:
The largest sector difference is in the technology sector. The U.S. has a much higher technology weighting than Europe, 20.4% versus 4.3%. On the other hand, Europe has higher weightings to materials, defensive, financials, telecom, industrials and energy.
Take a look at the super sectors to get in even higher level breakdown. Here are the super sector weightings:
Europe is overweight the cyclical and defensive super sectors while the U.S. is overweight the sensitive super sector.
Looking at the top holdings, this trade sells $AAPL, $GOOGL, $MSFT, $AMZN, and $FB to buy Nestle, HSBC, British American Tobacco, BASF, and Anheuser-Busch InBev. These American tech stocks have been some of the best performers over the past decade. This trade could be thought of simply as taking some gains on U.S. mega cap tech stocks to double down in Europe.
This trade sounds like a risk-off position, but the historical data clearly shows that Europe has been more volatile than the U.S. over the past 3 years. So Europe has had terrible returns and high volatility. This trade is a contrarian and mean reversion play against this horrible past performance.
The last graph is really the most surprising. The relative performance of the 2 regions is in stark contrast. Europe has been pretty flat for over a decade while the U.S. market has doubled. This return difference has been mainly driven by the earnings outperformance in the U.S. The U.S. valuation premium is between 7-26% which I don't view as excessive.
Which region is likely to have stronger earnings growth in the coming years? My sense of mean-reversion tells me that it will be difficult for the U.S. to continue to grow earnings faster than Europe given the magnitude of the current gap. I think Europe could easily close part of this gap over the next few years given the hurdles are set pretty low.
Europe stocks look to dethrone US counterparts as earnings beats hit 7-year high - CNBC
European Equity Barometer - Blackrock
Europe Earnings Outshine U.S. to Signal Long-Awaited Rebound - Bloomberg
MLP investments involve a higher degree of tax reporting relative to common stock investments in a typical C-corporation. Similar to a REIT, a MLP must distribute at least 90% of it's earnings to it's partners. The attractiveness of the ETF product in the MLP space is greatly reduced by the diversification rule limiting the amount of MLP investments to 25% of ETF assets. Therefore, most MLP ETFs are structured as C-corporations and pay corporate tax on dividends before distribution, greatly reducing the return offered by the MLP structure.
Looking for a MLP focused on renewable energy, and I found an interesting opportunity in NextEra Energy Partners, $NEP, managed by general partner NextEra Energy, $NEE. $NEP owns about 3.3 GW of renewable power producing properties, mostly wind and little solar. $NEP also owns 4 natural gas pipelines. $NEP trades at a yield in the low 4% range which is lower than most MLPs. $NEP does have a robust dropdown pipeline of projects and has guided to increasing the distribution by 12%-15% annually through 2022 off the year end 2016 annualized distribution of $1.41. If you believe management's guidance, the forward distribution and yield table looks like this:
Looking at this table, the current lower-than-MLP-average yield doesn't look so bad. You have to ask yourself how likely management is to achieve their guidance. The high level of dropdown projects makes their guidance look like a good bet. In this light, $NEP looks to me to be a buy.
1Q GDP forecast from Atlanta Fed fell off a cliff last week, dropping to 0.6% from 1.2%.
The market must be looking past the weak 1Q and expecting a bounce back in 2Q growth. If this bounce does not materialize, the market looks increasing vulnerable to a pull-back. Worse yet, the weakness is centered around consumer spending. Real consumer spending growth in 1Q was only 0.6%, down from 1.7% in 4Q, according to the Atlanta Fed. Consumer confidence numbers are heading up, but consumer spending is heading down.
This relationship cannot last forever. Let's hope the weakness is temporary. A good way to describe the American consumer is frugally optimistic. I continue to advocate a more conservative investment stance given the perplexingly optimistic market behavior.
3/30/2017 0 Comments
I have concerns over a disappointment in 1Q GDP growth. GDPNow stands at 0.9%, and its next update is Monday, April 3. Given the apparent lack of growth and the market's optimistic pricing of fiscal stimulus and tax cuts, I am inclined to be conservative from an investment perspective. I have been sniffing around for more defensive and yield oriented investments. What came onto my radar is the telecom sector. This is a countercyclical sector and the worst performing sector over the past year.
In addition to countercyclical sectors, I have been focused on sectors which have a relatively low correlation to the S&P 500 Index. Telecom does not have the lowest correlation, which goes to utilities then REITs, but it is lower than most other sectors. The utility sector has had a nice run up, and I might be more interested in utilities after a pullback. I do like the REIT sector, but this post will focus on telecom.
The telecom sector is relatively small at $1.9T market cap, and U.S. telecom is highly concentrated in $VZ and $T. Most of the other large telecom stocks are foreign businesses who issued depository receipts in the U.S. Given the high level of concentration and the low dividend yield of the telecom sector ETFs, I don't see an advantage to buying a sector ETF in this case. I would recommend buying either $VZ or $T directly to overweight the telecom sector. $VZ has not moved much in price for several years while $T has rallied from the low 30's to the low 40's. $VZ is also cheaper on a EV/EBITDA basis at 7.4x.
From a qualitative perspective, I don't view the 'cord-cutting' trend as disastrous to the telecom industry because customers still need to access the internet from either a cellular LTE or broadband service. Much of the weakness in telecom is a result of the 'cord-cutting' trend, and I view this secular shift as priced into the stocks at this point. Furthermore, I believe recent consolidation in the sector has lowered competitive pressures. More consolidation is also a possibility given the merger-friendly Trump administration.
$VZ has been financially levered at over 2x debt to EBITDA following the acquisition of Verizon Wireless in 2014, but the industry median leverage is higher, at over 3x. Although I don't regard telecom as an industry in the best financial health, it has stablity and significant barriers to entry.
Finally, I looked at the dividend yield. $VZ has a much higher yield than the utilities sector, 4.7% versus 3.0%. $VZ is paying out between 50% to 70% of earnings in dividends. I view this payout ratio as sustainable. 2016 was a pretty rough year for $VZ. Revenue was down 4% and eps over 20%. In 2017, revenue is expected to be flat to down a hair. Margin pressures are expected to ease leaving eps flat, good enough to easily maintain the dividend.
Since I am not feeling particularly bullish on the overall market in the short-term given the bleak 1Q GDP outlook, I am searching for stability and yield, not a supercharged growth stock. So $VZ fits the bill, and has some potential upside due to its low valuation and the friendly regulatory environment. I could see $VZ making new ATHs this year, a 16+% upside. That would bring $VZ's valuation in line with $T (8.6x) on a EV/EBITDA basis.
Neel Kashkari is the President of the Minneapolis Federal Reserve Bank. Kashkari was the only dissent at March 15 FOMC meeting, when the fed funds rate was increased by 25 bps to a range of 3/4 to 1 percent. Kashkari published an article, Why I Dissented, a couple days later to explain his decision-making process. This article provides clear insight into the mind of central banker who believes there is more slack in the labor market.
Kashkari first looks at inflation. The Fed's stated inflation target is 2% which Kashkari distinguishes from the ECB's inflation ceiling of 2%. Kashkari goes on the highlight the Fed's inability to accurately forecast inflation, pointing out medium-term inflation forecasts have been too high 100% of the time over the past 5 years.
Kashkari highlights contained inflation expectations.
Kashkari goes on to discount the market-based measures of long-term inflation expectations, because... "financial markets are guessing about what fiscal and regulatory actions the new Congress and the Trump Administration will enact."
Inflation is running low in most developed economies, not just the U.S..
Then Kashkari gets into the employment side of the dual mandate. He highlights the U-6 measure of unemployment which includes people who have given up looking for work or are involuntarily part-time.
Kashkari sees some remaining slack in the labor market from several sources. First, the U-6 unemployment rate is still 1% above the pre-recession level. Second, the recent relative strength in jobs per month (averaging 200,000 versus 80,000-120,000 labor force growth) has not moved the headline unemployment rate much below 5% because more people want to work than are being captured by the employment models and surveys. The employment-population and labor force participation ratios, for ages 25-54, also remain below pre-recession levels.
Kashkari admits the Fed does not know for certain the level of maximum employment and acknowledges this target changes over time. As evidence, Kashkari points to the Fed's own 5.6% estimate of maximum employment from 2012 which we now know was definitively too high. Kashkari sees the labor force continuing to grow, either by workers re-entering or choosing not to leave, which has kept a lid on inflationary pressure so far.
Finally, Kashkari says the current level of the neutral real interest rate is 'around zero'. With inflation at 1.7% and a target range for the real fed funds rate between -0.95 percent and -0.7 percent, Kashkari sees monetary policy as somewhat accommodative.
I like Kashkari's transparency. His opinion is worth a read.
3/16/2017 0 Comments
The Federal Reserve Bank of New York published an interesting research article, A Tale of Two States: The Recession's Impact on N.Y. and N.J. School Finances, by Bhalla, Chakrabarti, and Livingston. As the title suggests, the researchers examine K-12 funding and expenditure changes in N.Y. and N.J. schools following the Great Recession. The article details the effect of the federal stimulus program, the American Recovery and Reinvestment Act (ARRA) of 2009, on school funding. Finally, the article looks at state budgets, and how those impacted school funding.
The change in total funding per pupil is summed up by this graph:
N.Y. had a marginal decline in funding while N.J. had steep cuts of greater than 12% in each school year, 2008-09 and 2009-10. Most public school funding comes from three government sources: federal, state (sales & income tax), and local (property tax). Pre-recession in 2008, school funding in N.Y. and N.J was pretty similar:
After the Great Recession, school funding in both states experienced significant shifts. N.Y. received a much larger increase in federal funding, and N.J. suffered a larger cut in state funding. These charts signify the change in school funding by source.
The two funding channels that showed the greatest change were federal and state.
Federal allocation of ARRA funds to education was $97.8B. N.Y. received $4.4 billion more federal funding than N.J.. Some of this difference can be explained by demographics. First, N.Y. was eligible for more aid through the State Fiscal Stabilization Funds ($53.6B) simply because it was a larger state. N.Y. ($3.8B) had 6.2% of the nation's population in age group 5-24, while N.J. ($1.3B) had 2.7%. Second, Title I funding ($10B) was for low-income schools. N.Y. ($0.9B) had a greater proportion of students from low-income families, 46% vs 31% in N.J. ($0.2B). Third, IDEA Grants ($12.2B) were for special education students. The number of special education students in N.Y. ($0.8B) was greater than N.J. ($0.4B). Finally, N.Y. ($0.7B) qualified second in Race to the Top (RTT), a program designed to reward states with high-performing schools and educational improvements. RTT funding was dispersed to the top 10 states, while N.J. placed eleventh.
State funding also showed major differences. The first major difference is N.J.'s state law which requires the state budget to balance every year. A state budget deficit cannot be carried forward to the next fiscal year like it can be in N.Y.. In addition, N.J. state tax revenues declined much more than state tax revenue in N.Y. following the Great Recession.
In January 2010, Governor Chris Christie, facing a budget deficit, cut $475 million in state aid to N.J. schools.
I find this study interesting for several reasons. First, it quantifies part of the impact of the last federal stimulus package (total ARRA bill was $787B). Today, the federal government is again considering a stimulus program which would look starkly different due to its reliance on tax cuts rather than increased spending. Second, it quantifies the impact the recession had on two state budgets which one might assume at the outset to be quite similarly. Finally, the article shows how school budgets react to severe budgetary change.
A Tale of Two States: The Recession's Impact on N.Y. and N.J. School Finances by New York Federal Reserve Bank
The Atlanta Fed's GDPNow forecast of 1Q growth has fallen to 1.2% from 3.4% on February 1. What is behind this precipitous drop and should we be concerned about a slowdown from 1.9% in 4Q?
The Atlanta Fed publishes a historical breakdown of the contributions to the GDPNow estimates. The total drop in the GDPNow estimate is 2.1% (3.4% - 1.2% does not equal 2.1% due to rounding). The majority of the decrease, 1.4% of 2.1%, stems from PCE, or consumer spending on goods and services. The drop is PCE makes sense since it's the component of GDP. If more of the drop had come from inventory (-0.4%), government spending (-0.3%) or net exports (-0.1%), then it would be less concerning.
The next GDPNow update is March 15 which is 44 days before the GDP report is scheduled to be released on April 28. FRB Atlanta publishes the report below on forecast error over time.
So the current forecast is 1.2% plus/minus 1.4%, a fairly wide band. Upcoming GDPNow updates are scheduled on March 15, 16, 24 and 31.
Are other GDP forecasts also showing weakness? The NY Fed's Nowcast stands at 3.1%, not showing the recent slide in growth GDPNow is picking up. The Cleveland Fed's monthly forecast is 1.8%. Moody's Analytics forecast is 1.0%, and Moody's forecast has come down quite a bit since February, similar to GDPNow.
CNBC Rapid Update is a weekly survey of Wall Street economists' estimates of current quarter GDP growth. The CNBC Rapid Update stands at 1.5%. The WSJ Economic Forecasting Survey polls Wall Street monthly and is currently 2.2%. The Philadelphia Fed publishes a quarterly Survey of Professional Forecasters last updated February 10, which has 1Q GDP growth at 2.2%. One nice element of this report is it shows the change in the forecast from the previous forecast prior to the election.
The change in the current forecast from the previous shows when economists believe the pickup in growth will occur. The growth forecast for 2017 only increased from 2.2% to 2.3%, with 1Q unchanged. The larger increase in growth is in 2018 and 2019 which both increased from 2.1% to 2.4% and 2.6% respectively.
There is a disconnect between the business and consumer surveys and the hard economic data right now. Part of this difference is due to timing because easier financial conditions, improved confidence and expectations for fiscal stimulus take time to feed into the economic data. Therefore, the growth acceleration story remains intact even with a weak 1Q GDP print. The question is how long the market will wait for the strong data to surface. The disconnect between the perception of growth and the actual data must narrow eventually. Either the data will strengthen to confirm the pickup in growth, or the perception of an impending bump in growth will come back to the reality of continued subdued performance.
The stock market has priced in a pickup in economic growth subsequent to the 2016 Presidential election. If this acceleration in growth does not materializing at some point, the market may be vulnerable to a reversal.
I stumbled upon a research article titled, Stuck in Part-Time Employment by Jonathan L. Willis at the Federal Reserve Bank of Kansas City. The analysis is interesting because Willis divides the labor force into 3 skill segments (low-skill, middle-skill, and high-skill) and notes the number of jobs in the middle-skill segment continues to languish below pre-recession levels while both the low-skill and high skill segments have long surpassed pre-recession highs. Willis explains the economic forces behind weak job growth in the middle-skill segment are likely structural, possibly due to advances in technology and increases in globalization.
"... the economy has five million fewer middle-skill jobs than in December 2007. If the employment growth rate over the past four years continues, it would take an additional 13 years for the number of middle-skill jobs to return to December 2007 levels. Given this long-term weakness in labor demand, elevated PTER (Part-Time for Economic Reasons) in middle-skill jobs appears to be a structural issue."
Willis goes on to contrast this with job performance in the low-skilled segment, which surprisingly maintained positive job growth during the recession. Therefore, the weakness in low-skill jobs was likely a cyclical factor, explains Willis. The level of PTER in the low-skill segment has steadily decreased during the recovery. If the labor recovery continues, PTER in the low-skill segment will return to pre-recession levels by mid-2020.
Finally, Willis notes demand for high-skill labor has been the strongest segment.
I thought this analysis was quite insightful into the dynamics of the U.S. labor market, particularly relative to the typical 2 segment breakdown of low-skill versus high-skill.
Michael Grove, CFA