The Great Rate Abate

”What is easiest to see is often overlooked”. – Milton H. Erickson

After two years, could it have been for the entirety of that time that it really was so simple? Recollecting how many thousands of words have been written debating the prospects for economic recession, inflation rising or falling and the prospects for a notable decline in the stock market due to falling corporate profits, one is struck by how many false paths have been followed. Could it be that the entire time we were gazing into our crystal balls attempting to divine the future, what we were most fearful of was what was being experienced? What if the bear market we were so afraid of experiencing these past two years, due to our need to navigate our way through an aggressive Federal Reserve rate tightening cycle, is not something we need fear as part of our future but is now part of our past?

From January 1, 2021, through May 31, 2022, the consumer price index had risen at a 9% annualized rate in those seventeen months with 10-year US Treasury rates tripling from .93% to 2.85%. From June 1, 2022, through October 31, 2023, the annualized rate of inflation has fallen to 2.6% but with Treasury rates continuing their rise to 4.88%. In the past two years through October 31, 2023, the two-year total return of the S&P 500 of -5.95% obscures the true state of negativity of the financial markets. 60% equity & 40% fixed income portfolios have declined 15.64%. The version of the S&P 500 with each stock in that index equally weighted has declined 13.9% and the S&P 600, an index of US small cap stocks, has fallen 18.6%. The price of the average investment grade taxable bond in the United States has declined 15.4%. Of the major asset classes only gold and commodities have provided investors with positive returns.

With Jay Powell preparing to take his victory lap for having placed the inflation genie back in its bottle, it might be interesting if we were to pause to consider the strength of the correlation between the falling inflation rate and the timing of the fed rate increases, which began in March 2022. Three months after that first rate increase, the inflation rate reached its peak in June 2022, although the fed had only raised interest rates by 1.5%, or less than one-third of the total of the 5% increases from March 2022 to its most recent increase on July 25th of this year. Energy prices had risen by 70% from October 2021 to June 2022. Since then, they have fallen 34%. Is that the fed’s rate increases or geopolitics? What about all of the press conferences in which Jay Powell stated that inflation was unlikely to fall to acceptable levels without a slowdown in the rate of economic growth? If this was true, then why has the rate of inflation fallen so significantly while the inflation adjusted rate of US economic growth has risen from 1.8% in the year ending October 2022 to 2.95% this past year? Perhaps the greatest mystery has been why so many of the American people have either been convinced, or perhaps convinced themselves, that the pain of higher interest rates has been in any way contributory to the return of the rate of inflation to close to its pre-pandemic levels.

Let’s be clear that the Federal Reserve is responsible for setting the Federal Funds rate, an interest rate establishing the cost of overnight borrowing, NOT the interest rate on 10-year US Treasury bonds which is set by the supply and demand for those securities in the financial markets. Nonetheless, it is quite plausible to suggest that the increase in short-term interest rates has been a significant contributor to the rise in the 10-year treasury borrowing rate. It is also a simple matter to establish that the behavior of interest rates have been the single greatest contributor to the return, or lack thereof, of the equity markets. From April 1, 2021, through December 31, 2021, the interest rate on ten-year treasuries declined from 1.72% to 1.52% and the S&P 500 rose 19.8%. From October 1, 2022, through July 15, 2023, the ten-year treasury rate remained unchanged at 1.74% and the S&P rose 27.4%. The correlation is obvious and should provide a great deal of hope to investors in the financial markets. If the Federal Reserve is responsible for the raising of interest rates and the Federal Reserve is done raising interest rates AND equity markets only need stable if not declining interest rates to move to higher levels, then perhaps it is time to prepare for the possibility of much better times for investors in the not very far distant future.

60% equity & 40% fixed income portfolios returned -2.35% in October and are now up a miserly 1.48% for the year. The S&P 500 was -2.10% for the month though up 10.7% year to date. Mid-cap and small-cap stocks were both down over 5% in the month and both now show negative returns for the year with mid-cap stocks -1.30% and small-cap -5%. Foreign developed markets were -3.5% for the month but still +3% for the year. The story of the equity market year to date remains frustratingly consistent; a stock market that continues to rise on the backs of eight single companies; Alphabet (Google), Amazon, Apple, Meta (Facebook), Microsoft, Netflix, Nvidia and Tesla. Netflix is the worst performing of the eight returning 39.6% and NVIDIA the best returning 179%. The eight companies now represent just under 50% of the S&P 500 Growth Index which explains that indices 15.26% return year to date though down notably from its return of 26% on July 28th.

Mark H. Tekamp/November 7, 2023

Strive for Five!

Best things dwell out of sight, The pearl, the just – our thoughts. Most shun the public, are legitimate and rare. “Best Things dwell Out of Sight” – Emily Dickinson

The Wall Street Journal of September 29th treated its readers with a pair of kid gloves headlining its article describing the performance of that month’s equity markets “Stock-Market Rally Sputters in New World of Soaring Bond Yields” as the months -4.8% return transformed the 3rd quarter’s return to a -3.3% and applying a haircut to its year to date return reducing that figure to +13.1%. S&P Dow Jones, in its commentary of the month’s market, chose to describe it as a market rally that “fizzled,” citing 10-year Treasury yields rising to 15-year highs, renewed inflation concerns and worries about the Fed’s “hawkish” guidance. Talk of “soft landings” seemingly went AWOL amid increasing references to the possibility of “crashes” and some market commentators citing what they perceive as parallels between current market conditions and those preceding the market conditions of 2008-2009. Proving that fear can be contagious, the needle of the CNN Fear & Greed Index now finds itself residing in the Extreme Fear space.

A consumer of commentaries on the economy and financial markets should be struck by the increasing length to which those commentators are going to find evidence to support their narratives. Demography, one of the longest term of variables, is cited to support the thesis that inflation is likely to remain higher for longer. Federal budget deficits, which have been large for a long time, are now at a crisis point. Another reason for the likely persistence of inflation is that the US workforce has grown militant and increasingly prone to demand very high wage increases though only 10% of the US workforce is unionized. Another source of worry is that those same workers that are demanding significantly higher wages, as they spend down their pandemic sourced savings accounts, are viewed by some as increasingly likely to default on their credit card debt and sink under the burden of their renewed student loan payment obligations. What they do not include in their narratives is that those same households’ cost of servicing those debts, in relation to their income, is below that of any year in the past thirty-four years. And US corporations, which are claimed by some to be about to buckle under their need to refinance their debt at today’s much higher rates, are currently able to service those same debts at a cost that, in relation to our national economy, is at its lowest share in more than forty years and 40% lower than four years ago. Perhaps the greatest surprise for those willing to step outside the realm of opinion into that of fact is how stable this year’s economic environment is with a great many of the various indicators used to measure the current state of our national economic well being represented by close to horizontal lines; in other words, our national economy is very much in “steady as she goes” mode.

Why bother with the financial markets, the beleaguered investor may be forgiven for asking. 60 (equity)/40 (fixed income) moderate investment portfolios have created negative returns in the past twenty-four months. The losses aren’t large, likely near 6%, but why not just step over to the sidelines and roll over six-month Treasury bills paying 5 ½% with NO risk? No need to worry about inflation, recession, government shutdowns budget deficits etc. Once things “look” better, say after the presidential election next year, one can always get back into the market and experience the better days to come. This seems like such a sound proposition it is tempting to view its logic as very close to compelling. History though may offer a counter argument. We are either at or very close to the end of this rate hiking cycle; the seventh since 1984. In the prior six episodes the S&P 500 returned ON AVERAGE 20% in the succeeding twelve-month period. Market declines are the price investors pay to be in the stock market. Perhaps the price is close to having been paid. Perhaps the greater risk is missing the reward. Recent market behavior provides additional evidence to support the possible wisdom of not exiting this market. Call options are a “wager” on higher stock market prices and put options are their opposite. Negative wagers on this market are currently at the highest levels since two prior times this past twelve months. This first time, December 19th of 2022 the market was 10% higher on February 2nd. On March 8th the market was 15 ½% higher on July 28th.

Q3 2023 provided investors with something they had not experienced in the year’s first half, with the fixed income portion of the portfolio outperforming that of the equity. This was partially attributable to the equity market’s overall decline of 3% in the quarter. The fixed income share though, experienced modestly positive returns of 1.5% leaving 60/40 portfolios -2% for the quarter and +4.6% year to date. Equity markets in the quarter offered investors little in the way of safe harbors as most equity holdings created returns of between -2% and -4% with small cap stocks underperforming a bit more. The relatively good behavior of fixed income during the quarter was attributable to interest rates rising in the intermediate to longer term maturity range but shorter-term maturities remaining relatively constant allowing investors to earn their cash flow without declines in the value of their principal.

Mark H. Tekamp/October 7, 2023

Bytes, Apple & the Atom

When the woman saw that the tree was good for food, and that it was a delight to the eyes, and that the tree was desirable to
make one wise, she took from its fruit and ate; and she gave also to her husband with her, and he ate. Genesis 3:6

The news of the final trading day of August, if it was news, decidedly didn’t seem particularly “new”. “Morgan Stanley analyst predicts S&P 500 could leap another 11% this year boosted by “Magnificent Seven” stocks”. So opined Fortune. Apple Ends Historic Winning Streat. The i Phone 15 can’t come soon enough” from Barrons. And finally, from MarketWatch, “Alphabet Inc. Cl A stock outperforms market on strong trading day”. The hottest month of the year didn’t exactly warm up the financial markets but, perhaps anticipating autumn, it certainly did bathe them in a sea of red. S&P Dow Jones publishes a collection of sixty indices at the end of each month. Of the sixty fifty were red with the thirty covering the domestic stock market containing only three not of that hue. For the S&P 500 it might have been worse as the index was down 4.7% by the 17th prior to rallying 3.1% to finish down 1.6% for the month. The negativity was more pronounced everywhere else as small cap stocks slid 4.1%, midcap stocks 2.8%, foreign developed markets 3.7% and emerging markets 4.4%. Ten-year US Treasury rates starting the month at 3.97% hit a peak of 4.34% on the 21st finishing the month at 4.12%.

The most pronounced sound for those listening to the financial markets may have been that of the towels being tossed in by those market observers harboring opinions bordering the optimistic on the economy or the financial markets. The recession, though deferred, is most certainly coming. Inflation, though indisputably lower, may soon reverse course though that may not matter since Jay Powell seems determined to throw the rocks of higher interest rates until something breaks. The stock market is certainly overvalued, and US federal finances are in a state not too far distant from the catastrophic. Rather than seeking to speak truth to the market though, perhaps it might prove to be more profitable listening to what it is saying. Homebuilding stocks are up 20.6% in the past three months, more than twice the S&P 500’s 8.3%. The returns on those stocks most sensitive to the rate of economic growth are now outperforming those stocks least sensitive to it at a rate that is at ten-year highs. Finally, one of the best contrarian indicators has proven to be the rate of change at which investment strategists are lowering their price targets for the stock market. Century to date those levels have only been exceeded in 2003 and 2009, years AFTER major bear markets. What’s not to love?

Peter Thiel is famous for having said “you can invest in companies that deal in bits or you can invest in companies that deal in atoms.” This was his exhortation to invest in companies that are asset light and knowledge intensive (technology) rather than those that are asset heavy and make stuff composed of atoms (industrials). Certainly, those who took his advice when he spoke those words in 2014 have been well rewarded. In 1997 the services share of the economy was 80% larger than that of the industrial. Today it is 170%. Interestingly though, there are a collection of businesses that exist within the Industry sector of the stock market whose returns have nearly doubled at 260% the 131% return of the Information Technology sector in the past five years. Companies composing that industry such as WillScot Mobile, MYR Group, IES Holdings and Primoris Services are not exactly household names. The companies we are discussing are in the Construction & Engineering business.

Could it be that our economy is migrating to a new era in which the rewards are earned disproportionately by those companies which make rather than break things? A not small part of the story here is that the industrial part of our economy has now reached a size where even modest shifts in favor of the industrial part of our national economy represent very large changes in revenue and earnings for companies that are just not that large. WillScot Mobile (WSC) for instance had revenues in the second quarter of $582 million versus Apple’s $81.80 billion, with the latter company’s market capitalization of $2.93 trillion exceeding that of the former’s $8.092 billion, making Apple 362 times more valuable. Finally, the Bureau of Labor Statistics (BLS) employment growth forecast for the period 2021 to 2031 is interesting with the five greatest expected growth rates being Support Activities for Mining, Electrical Equipment & Component Manufacturing, Power & Communication Lines & Related Structures, Utility System Construction and Building Construction.

As mentioned above, for investors August was a veritable sea of red but it might have been, and actually was intra month worse, as 60/40 equity/fixed income portfolios finished down for the month 2.6% but better by 2% than their levels on the 17th of the month. Only equity investors holding concentrated exposure to energy stocks saw green while everything else wasn’t. The equity share of portfolios, though down 2.6% for the month, is still showing handsome returns of +14.6% year to date. Fixed income though continues to lag as higher interest rates percolate their way throughout the yield curve creating negative returns of 2% for the month and -4.5% for the year leaving portfolios with returns of 7 ½% year to date.

Mark H. Tekamp/September 2, 2023

Fine Without China?

The sun sets behind the mountains and the Yellow River flows into the sea;

To thoroughly enjoy a thousand mile sight, climb up another level – “Climbing Stork Tower” – Wang Zhihuan

August 1st’s Wall Street Journal’s celebration of July’s stock market rise headlined “S&P 500 Extends Winning Streak to Fifth Month of Gains” was subdued with another story that day cautioning “Earnings Season Threatens Lofty Stocks. The Benefit of Owning Stocks Over Bonds Keeps Shrinking”. Indeed, though concerns about imminent recession and persistent and elevated inflation have continued to fade, there is also the reality of longer-term interest rates rising, a 14% increase in oil prices and the US Treasury’s announcement on July 31st of its plans to borrow in excess of $1 trillion dollars in the 3rd quarter. Issues that offer questions with uncertain answers.
The writer of this commentary proposes to discuss the influence of China in the life of the US economy and financial markets in less than one page, seeking to accomplish an objective that others have sought to achieve through a much more profligate use of words. The reason is that it is becoming increasingly apparent that the imbalances of the relationship between the two countries have now reached such extreme levels that the time of their reversal has grown near. That poses the prospect of dramatic change as well as challenges for the global economic and financial markets over the next ten years. So, it may well be wise for us to expend the effort to understand these changes and challenges; an effort we will attempt to accomplish through our exploration of four specific topics.

First is that while China’s and the US’s economies have a profound influence upon one another, they are in no way similar. The foundation of our economic system rests upon the employment of capital where it is possible for it to earn the highest rate of return. China’s economic system, in contrast, can best be described as a communal form which seeks the highest level of output through the full utilization of employment and other resources. This explains what is often referred to as “the hollowing out” of our economy as much of our economic capacity has migrated to China and its much lower costs of production. This is reflected by investment representing 43% of China’s economy versus 21% of our own, with personal consumption composing 68% of the US economy versus 38% of China’s.

Why this matters (point #2) is because China’s trade surplus with this country, $383 billion in 2022, is financed through its employment of debt which, since the global financial crisis of 2008, has grown at a rate much faster than its economy. While its total debt in relation to the size of its economy is half that of the US, our economy, when measured on a per-capita basis, is six times greater. This means that China’s ability to service that debt is one-third of that of our own. The global economic system must ultimately balance and so China’s trade surplus is the mirror image of US federal budget deficit, which now exceed the size of the US economy for the first time since World War Two. As the economist Herb Stein posited in 1986, “if something cannot go on forever, it will stop.”

Point #3. In 2000 China represented 7 ¼% of the global economy. It is now 18 ½% with that country the source of one-third of global economic growth the past forty years. It is the producer of 60% of the world’s cement, 50% of its steel and is the consumer of more than 50% of its aluminum, coal and iron ore. As a significant share of the world’s manufacturing capacity migrated to China, the cost of manufactured goods declined, leading to lower levels of inflation, falling interest rates and rising levels of global debt. Much of China’s trade surplus with the United States, and its resulting accumulation of US dollars, was recycled back to the United States through its purchase of US treasury securities, freeing up capital in this country for employment in the financial markets, explaining at least in part, the long running bull market in US equities.
Our final point is that the current geopolitical tensions between the United States and China should perhaps be understood as an effect rather than a cause. The two countries are destined to “decouple” from one another, not entirely but to a significant extent, because, quite literally, we can no longer afford one another. Each will go its own way and that, in the economic and financial sense, changes everything.

The July stock market was a dispenser of equal opportunities as the share of the market participating in the recent uptrend broadened significantly with the 5.5% rise in small cap and 4.1% in mid cap exceeding the 3.2% of the S&P 500. The value share of the S&P 500 returned 3.4% versus 3% for the growth, and energy stocks’ 7.3% return notably outpacing technology’s 2.6%. 60/40 portfolios returned 3% for the month with the slightly negative returns on the fixed income 40% pulling down the 3 ½% contribution of the equity 60%, leaving portfolio returns at 10% year to date.

Mark H. Tekamp/August 6, 2023

The Recent Past Won’t Last

Yesterday is a mystery-where it is today; While we shrewdly speculate flutter both away

Emil Dickinson – “Yesterday is History”

“Market Monster 2023 Rally Defied All Expectations” read the headline in the July 1st Wall Street Journal. “Stocks burst out of a bear market with the Nasdaq Composite up 32% posting its best first half of the year since the 1980’s” began the story. Interestingly, 2023’s first half return for the S&P 500 of 15.9% places it as tenth best in the years since 1951 serving as a counterpoint of 2022’s -15.6% as the third worst. (note that these are “price only” returns and do not include returns attributable to dividends). While technology stocks continue to grab the headlines Carnival Cruise Lines was the month’s best performing stock returning 67.7% for the month and 133.6% for the year with Delta Airlines the fifth best up 30.9% and 44.7% respectively. Providing further evidence of the notable broadening out of the market in June was the outperformance of small cap and midcap stocks returning 8% and 9% respectively versus the S&P 500’s 6 ½%. For those keeping score the S&P 500 is now just 6% from reaching its all-time high of January 3rd of last year.

With the rising temperatures of summer seemingly having sent the bear population back into hibernation perhaps it might be helpful to recognize the existence of some creeping shadows whose outlines are becoming visible. While not necessarily having a significant impact on our economy until next year we should not forget that equity markets tend to begin to discount such events approximately six months prior to their actual appearance. In the interests of brevity, we’ll focus upon just three; mortgage and student loan payments, the downward migration of the number of job openings in relation to job applicants and the coming depletion of the surplus savings of the US population.

The market for single family homes in the US is composed primarily of the resale of existing homes as that volume exceeds the purchase of new homes by a factor of seven to one. The average mortgage payment in this country is $1672 and most of those are fixed at rates of between 3% and 5%. At current interest rates the average payment is now $2300. Homeowners have been loath to sell their homes as evidenced by a near 20% decline in the volume of existing home sales year over year which has acted to support housing prices. The decision to move though, in most instances, is one that can be deferred but not postponed. Gradually, owners will sell, buyers will buy, housing prices will adjust downwards and increasing numbers of households will be faced with notably higher monthly mortgage payments. Add to this the US Supreme Court’s ruling on June 27th that 42.3 million Americans who have enjoyed three years of forbearance on making payments on their $1.6 trillion in student loans will need to start making payments in October on those loans averaging $275 month.

Investors stepped into 2023 being continuously reminded, by almost everyone with an opinion on the subject, of the inevitability of the coming recession. This year is now half over, and an increasing share of those prognosticators have come to believe that our national economy may slow but will continue to, at worst, muddle along. A significant likely contributing cause to our having avoided more challenging economic circumstances is the $2.6 trillion we received, primarily from the federal government, for pandemic relief. We’ve spent that down to $1.2 trillion as of April and, at the current rate of their depletion, household savings will be back to their pre-pandemic levels in just about a year.

Finally, many have been struck by the plethora of “help wanted” signs just about everywhere one is able to spend their money, as prominent as American flags at a 4th of July parade. This is a significant contrast to the first eighteen years of the 21st century when those seeking work outnumbered the jobs they were seeking. That started to change even prior to the pandemic but by the onset of 2021 job openings outnumbered those seeking them by over two to one. Currently we’re at 1.6 with that rate heading steadily lower. With that rate still elevated, workers losing jobs can easily find another so the slowdown in the rate of new job creation has not yet translated into higher rates of unemployment. But should the economy continue to experience a decelerating rate of growth, those losing jobs will end up becoming unemployed and the rate of growth in wages will lessen.

Ok. The end of June is the end of the month, end of the quarter and end of the first half of the year so lots of numbers. So far this year it’s been up to the equity part of the portfolio to do all of the heavy lifting of creating positive portfolio returns. Year to date the 60% of the portfolio that is invested in equities has returned 13 1/2% but with portfolio returns over that time returning +7% the 40% fixed income share has contributed -3% as stubbornly persistent and elevated interest rates remain that way. June contributed 6% or just under half of equities’ year to date returns. The great majority of the second quarter’s earnings were earned in June and roughly equal shares of those 7% portfolio returns were earned in both the 1st and 2nd quarters.

Mark H. Tekamp/July 8, 2023

Deflation Nation

No, time, thou shall not boast that I do change;

They are but dressings of a former sight – William Shakespeare, Sonnet 123

Many investors spent much of the month of May focused upon the negotiations in Washington DC on raising the debt ceiling of the federal government. Others chose to be enthused over Nvidia’s announcement of May 24th that the company was raising the estimate for its second quarter revenue from $7 to $11 billion leading to a torrent of prophecies of the coming Artificial Intelligence (AI) “revolution”. With that competition for investor’s attention the Bureau of Labor Statistics (BLS) release at 8:30 am on May 10th of the April Consumer Price Index detailing a rise of 0.4% for the month and 4.9% increase year over year passed relatively unnoticed. The number itself was as expected and failed to elicit much of a response from the stock market. Peeling back the various layers of the data though, it is becoming possible to discern that by the end of the year there may be a seismic shift in the Fed’s focus from that of prices rising too quickly to that of their actual descent.

The data the BLS uses to calculate the rise of used car prices and rents are several months old. We know that using more current numbers those prices are now falling and setting them at 0% in April would have given us a CPI number of -0.1%.  Producer Prices measure the prices that domestic goods and services producers receive; the “input” side of the US economy. Those prices rose 0.2% for the month and 2.3% year over year with actual declines in the prices of food, construction costs and transportation along with airfares, hotels and sporting events. The list of commodities trading at prices double digits below their peak levels of the past two years is a lengthy one and includes copper at -20%, coffee -28% lumber -78% and eggs at -82%.

Reasons for the onset of falling prices should be understandable for even a casual observer of the economy. Borrowing’s effect upon the economy is the opposite of that of saving as borrowing draws into the present what would otherwise have been higher future levels of demand. In the 32 years from 1990 through 2022 debt in the United States grew at a rate approximately 50% faster than its economy resulting in debt service representing an increasing claim upon the nation’s economic output and the declining rates of economic growth we are now experiencing. The result is an economy that becomes increasingly sensitive to the level of interest rates and thus more prone to the risk of falling prices as demand grows more slowly than supply. The effects of the $5 trillion spent by the US federal government to offset the economic effects of the pandemic are starting to disappear and M2 money, which had been rising at 27% in early 2021, is now showing an outright decline.

It may be wise for investors to begin to prepare themselves for the possibility of the federal reserve beginning to lower interest rates much sooner than the financial markets currently believe likely, creating the opportunity of taking advantage of a future that is only now becoming visible. Investors now crowding into money market funds yielding 4% and one-year certificates of deposit at 5% should entertain the possibility that rates in the not-too-distant future will make those only fond memories. Bonds which created equity bear market type negative returns in 2022 could be sources of equity market type capital gains. Utility stocks which have declined almost 8% year to date may find their 3% to 4% dividend yields once again an object of investor affection. High dividend stocks whose returns have underperformed S&P 500 by 10% year to date may return to favor.

Perhaps what investors should view as one of their most valuable assets is perspective. Debt is the overwhelming reality of our existence. Artificial Intelligence, debt ceiling talks and federal reserve meetings may serve as welcome sources of distraction but at the end of this day, and for a great many to follow, it’s likely that we find ourselves returning to the pre-pandemic world and this is an outcome that quite possibly we should welcome. The S&P 500 returned an average of 13.6% in the ten years preceding year end 2019. Simple logic should teach us that if the sources creating our current state of reality haven’t truly changed then perhaps the reality we should anticipate lies not too far distant in the past.

May delivered 60 Equity/40 Fixed Income & Cash investors a -1% return for the month and +2.5% year to date as a small rise in interest rates created -1/2% returns for bonds and just over -1% for equities. The change in the May equity market was notable as eight of the eleven sectors of the S&P 500 experienced negative returns with Technologies 9 ½% positive return once again being the notable outlier. Foreign developed markets were -3.7% headlined by Europe’s -5.7% pullback. Returns outside the US are likely explained by rising concerns about the continuing strength of China’s economic recovery.

Mark H. Tekamp/June 6, 2023 

Indices Mysteries

With no one to steer the course, a ship is like an unbridled horse.
Any system will rot to naught without a leader at the helm to direct
Valsa George “Captaincy”

Where is Jerome Powell? An inflation number was reported last week. Who cares? The Federal Reserve is meeting next week, and they may vote to raise interest rates further. Ho hmm. We were supposed to have had a banking crisis six weeks ago and since then the esteemed chairman seems to have gone missing. Certainly, things seem to have gone silent. The stock market couldn’t even make it to the front page of the Wall Street Journal’s April 28th edition having to settle for page B1 with the rather insipid headline “U.S. Stocks Advance for Two Months In a Row”. Insipid but nonetheless true as the S&P 500 rose 1.6% for the month making a new high for the year with a return of 9.2% for 2023 to date. Perhaps more than any year in recent memory though this is a market that is confoundingly difficult to measure with the Dow Jones Industrial Average rising 2.5% but the Nasdaq Composite barely positive with a return of only 1/10 %.

Temperature is measured by Fahrenheit or Celsius and distance by English or Metric systems, but the tools used to measure stock market performance are much more varied and potentially more confusing. For much of the past one-hundred years the Dow Jones Industrial Average was the preferred measure of US stock market returns but in the past several decades it has been superseded by the S&P 500 which is a “basket” of stocks actually numbering 503. Each of those individual stocks weighting in the index is based upon the current value of that company’s publicly traded shares, commonly referred to as capitalization, with the largest company in the index, currently Apple at 7.25%, and the smallest First Republic Bank at 1/300 of 1%, meaning that a price movement in Apple has 2,227 times the effect upon the S&P 500 than does First Republic Bank. The three most commonly used categories of stock market capitalization are large-cap, companies with a capitalization of $10 billion or more, mid-cap with companies between $2 billion and $10 billion and small-cap, companies from $300 million up to $2 billion. The shares of those three as a percentage of the total US stock market are 70%, 20% and 10% respectively. Note that the S&P 500 is composed of 84% large-cap and 16% mid-cap so as an index it modestly underweights mid-cap stocks and excludes small-cap stocks entirely.

The reason for taking this detour into the somewhat technical is that it leads to a rather large point which is that the indices we use to measure stock market returns are currently giving extremely varied rates of return and thus make it difficult to answer a seemingly simple question, “how is the stock market doing” and, more specifically, those indices became particularly confusing at two specific times, the release of an extremely surprising and positive employment number in early February leading to concerns about the likelihood of further fed interest rate increases and the “banking crisis” in mid-March. Examples abound but we’ll satisfy ourselves with the sharing of a modest number. A different variation of the S&P 500 is an equal cap weighted version with each stock in the index having an equal influence on its resulting value. From the start of the year through March 3rd the “normal” S&P 500 was +5.69% and the “equal weighted” version +5.56%. From that date through the end of April the returns are +3.29% and -2.74%. In the first paragraph the variances in the returns of the S&P 500, the Dow Jones Industrial Average and the Nasdaq Composite were noted. Year to date through month’s end those returns are 9.2%, 3.5% and 17.1%. Commonly used indices used to measure small-cap and mid-cap stock performance are the S&P 600 and the S&P 400 respectively. On February 2nd those indices were significantly outperforming the S&P 500 with returns of 13.8% for the 600, 12.3% for the 400 and 9% for the 500. From that date through April those returns are -12% for the 600, -7.6% for the 400 and -1.1% for the 500.

The variances in stock market returns also manifest themselves in the returns between different sectors of foreign markets and the US market as well. An index used to measure the performance of foreign developed markets (Japan, England, France, Switzerland, Germany etc.) is the MSCI EAFE. On January 19th EAFE was outperforming the S&P 500 by 5%. On February 6th those returns were virtually identical. On March 10th EAFE was again outperforming by 5%. On March 21st they were the same. As of the end of April EAFE is outperforming by 2.6%. German, French, Spanish and Italian stock markets are positive through April between 17.6% and 19.2% with French stocks outperforming the S&P 500 by 10%. China’s stock market was up 17.2% on January 27th, 11% more than the S&P 500%. Since that date through April China’s down 15.3% with the S&P 500 +3%. So, there we have it. If we knew what it all meant it wouldn’t be a mystery but it is and so we don’t. Though shrouded in mystery, our wager is still on the bullish side.

For 60 (equity)/40 (fixed income & cash) April was a walk on the mild side with the equity share +1.8% and the fixed income & cash returning -1% due to a modest rise in interest rates resulting in a +.40% for the month and approximately 3% year to date. For three months portfolios have acted like a teeter totter with moderate ups and downs leaving returns close to neutral.

Mark H. Tekamp/May 5, 2023

Going Without the Knowing

Every piece has a place that determines where you start
If a piece is missing from where the parts should meet
It distorts the whole picture and the puzzle can’t be complete – Anonymous

For investors focused primarily upon the behavior of the financial markets the first quarter seemed to offer a relatively normal recovery from a difficult 2022. Both bonds and stocks rose in value, so it wasn’t difficult to feel a sense of relief as last year’s 15% losses for 60/40 stock bond investors provided the welcome relief of 3 ¼ % profits. The onset of the new year offered the hope of something a bit better than that though as January represented close to the entirety of the quarter’s gains with February drawing down some portion of those profits and March restoring the greater amount of them with the S&P 500 rising 7.50% for the quarter and 3.7% for the month. The fixed income markets mirrored the equity markets by rising in January, falling in February and rising again in March. While a cursory glance of the equity markets might not reveal much in the way of the dramatic, a closer examination of the market exposes something a great deal more interesting.

The first hint of something interesting lying beneath the surface of the returns of the indices is by observing the dramatic variance in the returns of the indices themselves. The Dow Jones Industrial Average was up less than 1% but the Nasdaq Composite was up 17%. Of the eleven sectors of the S&P four, Utilities, Health Care, Energy and Financials, were negative. Three, Information Technology, Communication Services and Consumer Discretionary, were positive by double digits. Digging a bit deeper still one would discover that Information Technologies’ 21.6% return and its two largest companies, Microsoft and Apple, with a combined weighting of 44% of that sector and whose returns of 20% and 27%, representing 48% of that sector’s return, aren’t very far distant from one another. The truth that the stock market is back to riding on the returns of the “mega cap” technology companies is revealed by investigating the returns of the other two sectors. Second place Communication Services is dominated by the 38% weighting of Meta (Face Book) and Alphabet (Google) with respective returns for the quarter of those two companies of 76% and 17 ½%, explaining 76% of that sector’s return of 21%. Third place Consumer Cyclicals’ combined weighting in Amazon and Tesla is 34% and with returns of 23% and 68%, are responsible for 78% of that sector’s performance of 16%. So, we’re left confronting the reality of an entire index being dominated by the performance of six companies, representing 19% of the capitalization of the index, providing 69% of the S&P 500’s 7 ½% return for the quarter.

The onset of April brings showers, but it has also brought investors the welcome relief of the prospect of a Fed declaring victory over inflation and ending its rate rising cycle. In a world where debt is three times the size of the global economy, we’re well past the point of paying down the debt so we’re left with the need to refinance it by borrowing new money to issue new debt to replace the “old” debt as it matures. For the “treadmill” to continue to turn over the world depends upon the availability of collateral; the requirement for an asset to support the existence of the loan. The availability of that collateral is referred to as liquidity and since 2022, central banks, ostensibly concerned about levels of inflation, have caused global liquidity conditions to be a receding tide, leading to the inevitability of something in the global financial system breaking and indeed, the likely cause of the market declines in 2022. The current inverted yield curve, in which longer maturity securities pay lower rates of interest than those of shorter maturities, is an indicator of a lack of system liquidity. In March we had two banks in the United States requiring support to avoid the possibility of a larger problem in the banking system. Interestingly though, the onset of “the banking crisis” led to a recovery in the stock market as the S&P, whose year to date return had fallen to less than 1% on March 13th, added 6 ½% to that number by month’s end.

The future would now seem to be able to be seen with a bit more clarity. Until mid-month investors were caught up in a confusing mix of good economic news being bad financial market news due to the belief that the Fed wanted slower rates of economic growth in its quest for a lower rate of inflation. While the Fed denied that its response to “the banking crisis” at mid-month represented any sort of retreat from its policy, the reality of its response is likely to be characterized by a restoration of the pro-liquidity actions of its policy from the onset of the pandemic in early 2020 through 2021, as demonstrated by a dramatic narrowing of the yield spread between two year and ten year treasury rates from nearly 1% at the onset of the month to close to ½% at the month’s end. So, if we’re back to inhabiting a world in which good economic news is also good financial market news what should investors expect over the next several months?

The reality of a world characterized by very high levels of debt means that the provision of an adequate level of liquidity is the single most important determinant of the outlook for the stock market. As its insufficiency explains the negative returns delivered by the 2022 stock market, so is its restoration likely to be the source of the positive returns experienced by investors in 2023. Remember, debt is a global and not just a domestic phenomenon and with global capital flows of $170 TRILLION and the value of the US stock market $44 trillion a 5% change in the former represents a 20% change in the latter.

Mark H. Tekamp; April 10, 2023

Neither Teetering nor Tottering

I look like I’m stable; Like nothing can move me; I look like I’m steady, Like nothing will shake me; But really I teeter; To every work I flinch; But really I totter; To every change I break. Vishal Dutia, Teeter Totter

After making its 2022 lows on October 14th the S&P 500 provided investors a very nice recovery of nearly 16% from that date through February 14th. Marrying a much sunnier stock market to the economic and financial news was sufficient to provide investors the glimmerings of an early onset of Spring. A Fed near to done raising interest rates. Inflation cresting and on its way to lower levels. The economy showing a bit of a spark and our starting to hear talk of “soft landings”. Then came the release of the January payroll number on February 3rd with a figure of 517,000 shocking a market expecting a 188,000 number. The market became a bit more nervous seeing an onrushing hawkish Fed through its rear-view mirror wondering if it wasn’t about to crash the party. Then on February 14th came the release of the January Consumer Price Index number which, while in line with expectations, wasn’t good enough. The same day news of the highest rate of increase in personal spending in two years was sufficient to raise already elevated fears of a Fed, perplexed by the economy’s failure to submit to its will by revealing evidence of its deceleration, and so the S&P sacrificed 4% in the second half of a no longer quite so sunny February.

So, at this point let’s step back, look at the cards we’re holding, discuss how to best play the hand we’ve been dealt and see about the setting of expectations for what the rest of the year may be offering us. Demonstrating some measure of self- restraint, we’ll focus upon just three specific elements. That should provide us the luxury of covering each in sufficient detail that we should be able to walk away from this discussion in possession of some measure of clarity and light.

First, as has been mentioned in prior commentaries, the pandemic caused the inflation and it’s receding further back into time will be the cause of its decline. It was the pandemic that led to the “locking down” of the economy, its subsequent reopening, and the $2.3 trillion dollars the federal government paid many of us to stay home. That is $30,000 for a family of four. The economic consequences of closing down a $25 trillion economy are profound and even three years later those effects still linger. That is a piece of this particular puzzle often missing in the analyses of those who make it their business to study the subject and it contributes to the offering of prescriptions for a problem whose solution is likely not what they or the Federal Reserve are seeking to prescribe. Giving people lots of money while not providing its recipients the means of spending that money on the goods and services they would normally have sought to purchase created effects that have largely subsided but the current rate of inflation is a consequence that, while declining, is one of the effects that still linger.

Second, we come to the realization that the current vibrancy of our national economy is having a limited effect on the current level of inflation. Remember. It’s not the economy that is causing the inflation. It was the pandemic. The awareness of this removes the rationale for what the Federal Reserve is doing. As discussed in the first paragraph, the direction of the stock market was very clearly altered by the strength of the economic data which means the stock market is currently a believer of the following set of beliefs. The vibrancy of the economy is a significant contributor to the current level of inflation. Thus, the economy needs to slow down materially for the rate of inflation to decline. The Federal Reserve has been very aggressive in raising interest rates. The increases to date have failed to slow down the rate of economic activity making it necessary for it to raise interest rates for longer and to higher levels. Those rate increases will quite possibly push the economy into a recession leading to a decline in the level of corporate profits and the stock market. This is most likely not true, but most believe it is.

Our third point is that the price of something is what establishes the balance between supply and demand. When demand increases faster than supply the price of that something will increase. Financial markets are forward looking and react in the present to what they expect to experience in the future. The stock market made a low this past October and has since, even after February’s modest decline, recovered approximately half of its prior 22% decline. The current economic data showing an economy stronger than many expected is good news but does not match the very negative sentiment of investors towards the economy and the stock market resulting in the demand for stocks being currently low and thus their prices. As investors become increasingly aware that inflation has peaked and is declining and the economy will continue to be stronger than expected then the demand for stocks will increase and you, dear investor, will own an asset whose price will likely rise.

60 equity 40 fixed income and cash investors who celebrated the first month of 2023 with returns of 4.7% surrendered a bit less than half of those gains in February experiencing portfolio declines of 2.1% leaving a year to date return of 2.6%. The guiltiest party was the 3% decline in the equity markets with large cap value and foreign markets declining a bit more than that and small cap and large cap growth a bit less. The fixed income portion didn’t help though hurting less with losses of near 1% as rising interest rates made bonds worth a bit less than at the end of the prior month. The first half of the month actually added to January’s gains, so it was the market’s just over 4% decline in the month’s second half in which the damage was done.

Mark H. Tekamp; March 5, 2023

The Morn’ of the Foreign?

Nature’s first green is gold, Her hardest hue to hold…So dawn goes down to day. Nothing gold can stay.. – Robert Frost – Nothing Gold Can Stay

Investors may have been thrilled to realize that all that was necessary to restore the pre-2022 luster to the stock market was the simple matter of dropping the two at the end of the year and replacing it with a three. The Wall Street Journal enthused “Nasdaq Posts Best January Since 2001”. The S&P 500’s +6.28% return for the month was certainly a pleasure to experience but even better was the performance of small cap stocks (S&P 600) +9.49% and mid cap stocks (S&P 400) 9.23% returns. One quarter of the S&P 500’s return for the month actually occurred on the final day of the month with the market celebrating, from its perspective, the “good” news that working folks pay checks are starting to grow more slowly and the houses we live in are no longer increasing in value or at least not much. The market is clearly hoping that if the American people are able to demonstrate that the pain that the Federal Reserve has inflicted upon us is sufficiently great then maybe they won’t have to inflict much more of it upon us. We shall see.

The stock market took the month to remind those of us born in years when men named Eisenhower, Kennedy and Johnson were president that this is most definitely not the stock market we grew up with. Three of the eleven sectors of the S&P 500 were up 9% or more for the month. Leading the way was Consumer Discretionary returning 14.99%. One quarter of that sector is actually Amazon. Add Tesla into the mix and we’re at 38% of the total value of that sector in those two companies. Tesla, by the way, is worth ten times General Motors. Next up, Communication Services, returned 14.23%. Just under a quarter of that sector is Alphabet (aka Google) and with Meta (aka Facebook) we’re at 40%. In third place, Information Technology, returned 9.26% with Apple and Microsoft together representing 43% of that sector. It’s starting to look like déjà vu all over again. Big cap tech is back!

As pleasant as it’s been this month for investors in the good old red, white and blue, it’s the markets existing beyond our borders where returns for the month are so large it takes two numbers to represent them. Indices composed of the 50 largest Asian companies returned 12.48%, the 50 largest European companies 12.53% and the 40 largest Latin American companies 10.65%. Italian and German stocks were up over 12% and French and Spanish over 11%. Since September 1st of 2022 MSCI EAFE, an index of foreign developed markets, has returned 18.24%, dwarfing the S&P 500’s 3.46%. That is very interesting and well worth the taking of some of our time together to discuss both why and how long this may continue.

Once upon a time US investors could actually add to their overall portfolio returns by investing in foreign markets but that is getting to be quite a long time ago. The ten year average annual rate of return of the S&P 500 is 12.58%. Foreign developed markets have returned 4.96% and foreign emerging markets 1.49%. Returns in foreign markets, not to place too elegant a phrase upon it, rhyme with duck. Investors would have to had the life span of Bowed Whales and Giant Tortoises, together with perfect foresight, to view investing in foreign markets as having been a particularly good idea. Peering back through the mists of time we may recall a time when, prior to its becoming history’s longest lasting deflating asset bubble, the Japanese stock market was the world’s largest, thereby assisting foreign developed markets in their outperforming the US five fold from 1971 to 1988. From 1988 to 2002 the US matched Japan’s stock market’s deflation with our own inflation as the US outperformed foreign developed markets ten fold. For the five years, from 2003 to 2007, the US underperformed by half but since then, as previously noted, its been all USA all the time.

The extended and fairly dramatic variance in the performance of the two markets has left foreign markets valued at roughly 80% of the size of their economies in contrast to the US whose stock market is valued at just over twice that of our own. Not to get (hopefully) too “geeky” here but the contrasts in the valuation of the two market universes really are striking. Citing the US first and foreign developed markets second; Price/Earnings 16.92 vs 12.10; Price/Book Value (the liquidation value of a company) 3.20 vs 1.52 and dividend yield 1.88 vs 3.92. Before we wander off this path lets first define foreign developed markets which is one-third Japan and the United Kingdom. Adding in France and Switzerland gets us to half and tossing in Germany, Australia and the Netherlands to three-quarters. Emerging markets are two-fifths China and Taiwan. Add in India and South Korea and we’re at two-thirds. Add Brazil, Mexico and South Africa and we’re at 80%. So, just possibly, the variance in the valuation of the two markets has reached such extreme levels that this year may see a narrowing of that differential, not by the US’s failure to create favorable returns but by foreign markets creating returns more favorable still.

60/40 investors saw their portfolios experience returns of approximately 4 ½% for the month with the equity share contributing 6 ½% and the fixed income 1 ¼%. Investors’ portfolios, in the absence of significant deposits or withdraws, achieved their maximum values at year end 2021. The average investor experienced losses of 15% in 2022 so we’re now closing in on the need for an additional 10% to match their end of 2021 values and achieve new all time highs. The tail winds are growing stronger and the headwinds are likely to continue to abate so here’s hoping 2023 will be a year to celebrate!

Mark H. Tekamp; February 2, 2023