• "Kee" Points with Jim Kee, Ph.D.


    • Market Pullbacks
    • Election Year Returns

     

    Market Pullbacks

    Markets (Dow, S&P 500) were down over 4% last week and have pulled back over -5% since hitting their peaks a few weeks ago. Recent strong performers like the tech-heavy NASDAQ indices and small cap indices are off even more from recent peaks. Year-to-date markets are positive in the U.S. and negative for most of the rest of the world. Reasons for the sell-off have ranged from President Trump’s comments on the Federal Reserve and trade with China, to IMF reports downgrading global growth, to mid-term election concerns of an impeachment movement should Democrats sweep the House and the Senate (not the consensus scenario). I think strategist Jason Trennert’s take, though somewhat unsatisfying (Barron’s) is probably best, “the proximate cause for the market’s dip reflected mainly a desire to book profits in the big winners."


    Market declines like these are very normal. For example, Yardeni Research notes that we’ve had 23 declines of -5% or more in the past 31 years, of which 3 turned into bear market declines of 20% or more. Believe it or not, counting up how many -5% or more declines occur in any given year is pretty hard to do and somewhat subjective. For example, if a market falls -5%, pauses, and then falls another -5%, is that two -5% declines or one -10% decline? How long does a pause in between declines have to be to make each a distinct episode? One day? A week? Some researchers (e.g. American Funds) use a 50% recovery of lost value to distinguish one decline from another. By that measure, and using data going back to 1900, the market averages about 3 pullbacks (i.e. declines greater than -5%) per year, and averages one correction (decline greater than -10%) per year. A “bear market” occurs about once every 3.75 years. Others (J.P. Morgan) use a slightly different methodology and find the market averages about one -5% decline per quarter, or 4 pullbacks per year. Perhaps even more importantly, Morningstar research shows that in years with double-digit stock market declines, the majority (63%) end up positive for the year.



    Election Year Returns

    What about mid-term election years like the one we’re in? Well, on average at this point in the year U.S. markets are up about 90 basis points (.9%) in mid-term years, which is below this year’s 240 basis point (2.4%) year-to-date performance. And typical mid-term years tend to have a strong post-election bounce, finishing up 6.1% for the year on average. So it is worth restating that market declines like the one we are currently experiencing are normal, “expected but not predictable,” as we like to say. The bigger threat to investor well-being is to believe (and act) otherwise, that is, to believe that market declines are expected and predictable.


  • "Kee" Points with Jim Kee, Ph.D.


    • Quick Overview
    • Rising Rates and Fixed Income Opportunities

     

    Quick Overview

    Stocks sold off a bit last week after reaching all-time highs as 10-year Treasury yields moved above 3.2%. I talked about interest rates and stock market valuations last week, so I won’t go into that here except to say that I don’t know any economists who are comfortable with sub-3% interest rates. And frankly, for a mid-term election year, it feels like stocks have gotten a little ahead of themselves. US economic news has been good for sure, with strong GDP growth, jobs numbers, Purchasing Managers Surveys (PMIs), and corporate profits (earnings). I just thought a lot of that had been priced in (nobody has a market valuation model good enough to really know). Rising US rates and a stronger dollar are also putting pressure on emerging markets (down -13% this year), many of whom have borrowed in dollars. A stronger dollar means that it requires more units of their currency to exchange for dollars to service their debt. I would reiterate though that wealth is created by production and exchange, and most emerging economies need to focus on monetary policies that facilitate production and exchange, which means policies that are stable and transparent. That does not describe most emerging markets, which is the real reason why many of these economies have been “emerging” or struggling for a century or more, not US monetary policy or global exchange rates movements.



    Rising Rates and Fixed Income Opportunities

    Speaking of interest rates, Josh Hudson, CFA, our Director of Fixed Income, is ecstatic about the recent upward movement in interest rates. That is because we build laddered portfolios of individual bonds, and we have been positioned for rising rates. A ladder means we buy bonds of varying maturities, so we have bonds constantly maturing (being paid off), the proceeds of which can be reinvested at higher rates. And because we hold bonds to maturity, we don’t have to worry about bond price declines because our clients will be paid back the par or initial issue value of their bonds, not the current (lower) market prices. Bond discussions are a good example of things that need to be “Barney’d up,” to quote a recent academic (who borrowed the phrase from the Marines). It means that if a big purple dinosaur can’t understand it, you’re probably not explaining it right! With respect to rising rates, Josh put it like this:


    “To put current yield levels into perspective, the 2-year Treasury yield is now where the 30-year Treasury yield was three months ago. Let that sink in for a moment. You can now earn the yield in the 2-year part of the yield curve that you had to extend out another 28 years to get back in July. There is nothing to say that bond yields may not get more attractive from here, but when we hit multi-year high yield levels, and especially in such a short window, we can’t ignore the opportunity to invest.”


  • "Kee" Points with Jim Kee, Ph.D.

    • Midterm Elections
    • Interest Rates and Stocks
    • Growth Stocks and Value Stocks

    Midterm Elections

    Midterm elections (November 6) are getting so much attention that Barron’s published its first-ever policy-themed roundtable over the weekend on the subject. I’ll just summarize the consensus view, which was that Democrats will win control of the House of Representatives while Republicans will retain the Senate. That outcome, it was widely conceded by the Barron’s panelists, would be bullish for infrastructure spending in the U.S. As political strategist Greg Valliere has pointed out (not in Barron’s), even if we had a “blue wave” Democrat takeover of the House and the Senate, the business tax cuts already passed would be safe via President Trump’s veto power through 2020. Most felt that markets were fair-valued, and certainty not cheap. Abby Cohen of Goldman Sachs made the interesting point that Democrats are backing off of impeachment talk prior to the midterms for fear it might energize the Republican base. Dan Clifton at Strategas made the interesting point that the S&P 500 has not declined in the 12 months following midterm elections since 1946. 


    Interest Rates and Stocks

    Abby Cohen also talked about developed-world bond yields being too low, i.e. their bonds are overpriced, which makes U.S. yields attractive to them. “The global environment keeps our yields lower than they otherwise would be,” said Cohen. She also pointed out that 37% of the U.S. Treasury market is owned by non-Americans, as is 29% of the U.S. corporate bond market. Many fear higher rates here could put a damper on U.S. stocks by raising the rate by which corporate earnings are discounted (i.e. "the discount rate"), which would result in lower equity values. Without getting into the weeds of discounted cash flow modeling too much here, models that use the U.S. 10-year treasury rate to value the market are not very good at all! 


    The discount rate is set by investors in the aggregate, with interest rates like 10-year treasury being a part of it. But so are investor's expected taxes (dividends and capital gains), expected inflation rates, and expected overall global risks or the “equity risk premium.” It is quite possible for interest rates to rise, but to have the overall negative impact of this rise on market valuations negated by offsetting positive changes in these other variables (including corporate earnings). For a simple example, interest rates as measured by the 10-year U.S. Treasury yields declined to a low of 1.37% in July 2016 before rising to current levels above 3%. That’s more than a doubling of interest rates, and yet during this rise equity market valuations increased 36%. This is partly because corporate tax cuts led to increased earnings, and the increase in earnings dominated or more than offset the increase in interest rates on overall market valuations.


    Growth Stocks and Value Stocks

    Finally, the lead article in this week’s Investor’s Business Daily caught my eye, “Growth Stocks Outrace Value.” Growth stocks have had such a dramatic run relative to value stocks since 2010 that they have now outperformed value stocks measured over the past three decades. I think that has led many investors to conclude that they should be allocated 100% to growth stocks. The article pointed out that the last time this occurred was just before the dot-com bubble burst, though that wasn’t a prediction. Interestingly, if you ran the data prior to this bull market, which economist Victor Canto did for his book, Understanding Asset Allocation, you would conclude that the ideal long-term asset allocation would be just the opposite - 100% value stocks! So the lesson of this bull market is that you don’t want to be invested 100% in value stocks, just like the lesson of previous markets is that you don’t want to be 100% invested in growth stocks. Owning both gives you the diversification benefits of two asset classes that tend to offset each other in the short run while both go up over time. In short, diversify. That’s what the Nobel Laureates mean when they tell you to usethe markets through diversification rather than trying to outsmart them.


  • "Kee" Points with Jim Kee, Ph.D.


    • Market Valuations
    • Today’s Monopolies versus Old School Monopolies
    • Economists on the Question of Monopoly


    Market Valuations

    Stocks (US) started the year strong, rising almost 10% into late January before a sell-off that lasted through March. Then they bounced up and down for a while (this is all pretty typical midterm election-year stock market behavior). But last week US stocks finished at all- time highs, even though the market’s valuation level as measured by the price-to-earnings (P/E) ratio is well below its January peak. That is because earnings have been so strong, which is the denominator of that ratio. The P/E ratio hit 18.5 in January, meaning stock prices were “eighteen and a half times earnings,” but is currently at 17, because prices have not risen as much as earnings have risen (i.e. the numerator didn’t increase as much as the denominator). In other words, stocks were more expensive in January than they are today.



    Today’s Monopolies versus Old School Monopolies

    A recent Wall Street Journal article caught my eye, “The Antitrust Case Against Facebook, Google, and Amazon.” The article compared market shares of new “monopolies” with those of monopolies of old, and it is pretty interesting stuff. For example, Amazon has about 75% of the electronic books market and about 44% of online commerce. Apple has about 54% of mobile operating systems. Google has 42% of online advertising revenues. By comparison, in 1896 General Electric had 75% of the electric lamp market; by 1904 Standard Oil had 87% of the market for refined oil products; AT&T processed 93% of phone calls in the 1930s, and by 1971 Xerox had 86% of photocopier sales and leases.



    Economists on the Question of Monopoly 

    The question of how much market share is too much has a long and conflicted past in economics, and a lot of it centers around the appropriate definition of what constitutes monopoly power, as opposed to competition (which is why the word “monopolies” above is in quotations). Some economists view an industry dominated by one or a few firms as monopolistic, and implicit in this view is the notion that the market has been cornered by a single firm, usually by restricting entry of new competitors through nefarious means. That should lead to more pricing power, or higher prices than would otherwise be the case. But others, most notably economist Harold Demsetz at UCLA (circa 1973) advance an “efficiency” explanation which argues that, in a world that is truly competitive, the best should take share from the worst, which leads to a handful of dominant firms in each industry. So one view sees a few dominant firms as indicative of a lack of competition, while another sees it as the logical outcome of competition.



    Does Facebook have a monopoly? The share of social media account holders with a Facebook account in 2017 was 94%, so it would appear so. But what did people do before Facebook? They networked and kept in touch by making phone calls and writing letters or emails, which is still an option open to all but is much less efficient. And driving to the mall to shop is also still an option instead of using Amazon, and landlines can be chosen instead of an Apple iPhone. And as for Netflix, you can still do the alternative, which is to buy a TV Guide (it still exists) and hope one of your favorite shows gets programmed. And of course instead of using Google as a search engine you can drive to the library and use the card catalog, if your library still has one! (most are in historic small town libraries). All of these firms have dominant market shares and could be considered monopolies or near-monopolies, and yet all of them are more efficient (lower cost to the customer) than what they displaced.


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