Second Quarter 2019
A lot of “sound and fury”, but not a lot of incremental progress. Stock market averages end close to where they ended the first quarter. Investors have had to contend with concerns of global economic slowing, increased tariffs, and monetary policy that might be out of step with international pressures. But the good news – averages are still near recent highs; not a lot to complain about.
Investors still seem to be optimistic that some agreement with China will be made and that the Federal Reserve will lower interest rates. The bond market already has for longer-dated maturities. In-the-meantime, the U.S. economy continues to look healthy. The consumer is in good shape; the only concern is that corporate capital investment has been lagging.
Our economy is 60-70% consumer based, but future growth does depend upon continued business investment. Investment may be lagging as leaders pause to see how the stated concerns work out; so hopefully the investor optimism is fulfilled.
The big surprise in financial markets this past quarter is how fast and far interest rates have fallen. It seems clear that international money flows have a great deal to do with our domestic rates. Interest rates for sovereign debt in parts of Europe and Japan are negative. Except for institutions that must keep a certain level of funds in their own country’s debt, there is a strong pull toward U.S. debt that pays far higher yields.
This additional demand bids up bond prices, which lowers yield. Even though our domestic economy is strong, our rates are being influenced by international circumstances. Unfortunately, interest rates that are lower than our domestic economy really calls for, encourages uses that may not be sound if rates were higher. As a result, we have increasing concerns about our fixed income market and the quality of many of the new obligations being issued.
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Some of our investors periodically ask us, “how are the money flows?” They know we keep track of this metric. The measurement is actually an indirect one and more accurately tracks buying or selling pressure on individual stocks. When a preponderance of stocks in a sector or in the market at large is reflecting buying pressure, we say money flows are positive for that category.
Tracking actual money flows into the market is virtually impossible. There are so many sources. Flows may come through dark pools, which are designed to keep sources and participants private. Companies may be buying back stock or have dividend purchase plans, among others. Some stocks trade on foreign exchanges as well as our domestic ones. There are many ways to disguise buying or at least not be so visible. Selling is harder to hide; when stocks go down there is selling.
What can’t be camouflaged is individual stock behavior. If a stock consistently closes at a higher price than its daily average, then it is showing buying pressure. When most stocks are showing the same, then money is coming in and pressuring for higher prices. Higher prices may occur immediately or have delayed reactions once individual supply at any price level is absorbed. We have stated that we are seeing positive money flows. What we are more precisely saying is that most stocks are showing positive buying pressure.
We also like to know how individual stocks are being treated in the marketplace. It is another piece of information for our consideration. We then overlay our fundamental analysis along with a longer-term perspective. We invest for a 3 to 5-year investment horizon. If companies are still good investments, we may hold them for much longer; Talk with Us.
No recession since 1991; that’s the experience of the Australian economy. This fact belies the opinion that expansions have some sort of defined lifecycle. And so, our economy marches on; the expansion may eventually end, but not yet. First quarter GDP growth was at a 3.1% rate. The second quarter is predicted to be much less.
Growth this year may show more variability from quarter to quarter than usual. This may result from businesses stock piling inventory from China to get ahead of possible tariff actions. This inventory will need to be worked off before new orders are given; so more stop-start than usual.
Precisely how much U.S. economic growth we can expect this year may be impossible to forecast, it does seem that growth will continue. Revenues will increase and profits expand. This is a good recipe for higher stock prices.
Higher stock prices are what we expect. Although we do expect the composition of the advancing averages to change. Large-cap growth stocks have led the market averages higher for years. We believe we are seeing a shift to many companies and sectors that have been left behind. Among them are industrials, material stocks, and financial companies; especially banks. Companies in these categories are cheap and overlooked. Certainly, the previous leaders can still do well, but we have doubts about their ability to ascend to new highs.
What we are describing is a style shift from growth to value stocks. It is still early but it does appear to be taking place.
Unfortunately, interest rates that are lower than our domestic economy really calls for, encourages uses that may not be sound if rates were higher. As a result, we have increasing concerns about our fixed income market and the quality of many of the new obligations being issued. Quality has been declining, yet investors, hungry for yield, are again reaching for the promise of higher returns.
Reaching for yield in lower and lower quality fixed income instruments contributed to the financial collapse 10 years ago. Structured bonds, collateralized loan and bond obligations are again making the rounds. This is not a good trend.
Corporate debt has greatly expanded over the past number of years. Some companies have found it irresistible to issue bonds to buy back stock. They hope that increased earnings per share due to the reduced count will more than offset the increased interest costs. This is usually a foolish bet. Earnings may fall in the future for any number of reasons, but the debt and its costs will remain. We fear that many of these instruments may take markets into another crisis when rates inevitably rise. This is not an imminent risk, but one that we need to keep our eyes on.
RCM is fully invested. Money flows are so strong into our stock market that the outlook for higher prices looks excellent. Business fundamentals are still mostly good. There are some concerns developing, we are keeping our eyes on them, but, so far, the good overwhelms the bad.
Where to invest has been changing. There is a slow, uneven rotation out of the leaders of the past to cheaper, passed-over stocks that may be more sensitive to the business cycle. Some resolution of the trade war with China may complete the change of leadership. This is a transition from growth to value in investment style.
At his point, RCM’s strategies have a leg in both camps. Our emphasis has been on the individual outlook for each company. However, if the move to the value style becomes more emphatic, we will also make further shifts.
It seems silly to commit to anything but relatively short maturities in fixed income instruments. Most of the yields obtainable from 5-10-year bonds are available in maturities under 3 years; why take the risk in making long-term commitments for rates this low.
There has been little joy in investing for these low rates. We only do it to control risk or to meet investment policy mandates from some of our clients. Quality is paramount; this is no time to take risks on new untested instruments. We like U.S. Treasury obligations and FDIC guaranteed brokered CD’s.
However, for income needs, where appropriate, we are far more enthusiastic about buying higher yielding dividend paying stocks. Not only does the client own good companies with growing earnings, dividends have been growing too; appreciation with increasing income.
as of 6/30/2019
|Large Cap Stocks (S&P 500)||17.3%|
|Dow Jones Industrial Average||14.0%|
|Mid Cap Stocks (S&P 400)||17.0%|
|Small Cap Stocks (Russell 2000)||16.2%|
|Barclay Aggregated Credit Index||9.7%|
“The individual investor should act consistently as an investor and not as a speculator.”
— Ben Graham