“But there was more to his story than just stellar financial results. He had left his previous employer, Goldman Sachs, after questions about his trading activity. And now, Mr. Hadden is under investigation over his trading in Treasury futures while at Goldman, according to a regulatory filing.”

“Specifically, regulators at the CME Group, which runs commodity and futures exchanges, are investigating whether Mr. Hadden’s purchases or sales of Treasury futures late in the trading day manipulated closing prices in the market and, in turn, made other of his trades more profitable, according to people briefed on the matter who were not authorized to speak publicly.”

“Mr. Hadden is one of the highest paid professionals at Morgan Stanley and has been known throughout his career for aggressive and profitable risk taking.

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Matt Will, an associate professor of finance at the University of Indianapolis, writing in the Indianapolis Star in June, referred to recent trends in disposable per capita income to argue that the Indiana economy is running on all cylinders.[1]  As a life-long Hoosier Republican in this our 200^th year, I too am very much interested in how Hoosiers have done, especially since the election of 2004 in which we held the Indiana Senate and took the Governor’s office, through most of which time we have also held control of the House of Representatives.

Alas, as our great Hoosier philosopher, Abe Martin of Brown County, said, “Figures don’t lie, but you can group ‘em so they’ll answer th’ same purpose.”  Back in our own locker room, I regret that I am not as impressed with our performance as Professor Will.

Per capita income, based on an average, has been deceptive.  In the extreme, if I am making $100 and enjoying pay increases, while four others are just getting by making $20 and without increases, then our average is $36 and increasing. In this extreme example, the median of the five of us, however, is still making $20 and struggling, no matter what the average is doing.

So we should ask how the median Hoosier household is faring.  The answer isn’t pretty.

From 2004 until 2015, the latest full year for which data is available, real median household income has risen 1.6% in the U.S., but it has fallen 2.1% in Indiana.[2]   Had income in Indiana at least kept up with the nation, Hoosier working class households might each have nearly $2,000 more to spend on goods and services annually. Figuring in state and local taxes doesn’t seem substantially to improve the picture for our after tax income.[3]

While Will did cite median incomes to boast of superior gains from 2008 forward, from the economy’s peak in 2007 Indiana’s median household income has fallen over 4% compared to the nation’s drop of 1.6%.

Over 50% of Indiana’s counties have been depopulating, [4] an ominous sign of their decline.   Meanwhile, the expanding Indianapolis metropolitan area is netting growth only from its surroundings, not from out of state.[5]  In total, our low cost of living should therefore be read as struggling demand for goods and services, especially for housing in our rural counties.  Hopelessness and lack of economic opportunity have combined to make Indiana’s rural counties among the nation’s leading producers and consumers of meth, a cottage industry.[6]

Our great poet, James Whitcomb Riley, in My Ruthers, extolled the Hoosier desire for independence when he wrote:  “I tell you what I’d ruther do – ef I only had my ruthers – I’d ruther work when I wanted to than be bossed round by others”.  So how is entrepreneurialism doing in Indiana?

Poorly.

Indiana ranks 44^th out of 50 states in business start-ups[7] (the worst of all our surrounding states) and 45^th in small business ownership.[8]   Who replaced the Federal government in 2016 as our largest employer, having driven out of business so many local economic mainstays?  Walmart.[9]

Our grandparents’ generation levied taxes and broke up concentrated wealth so that our parents’ generation could graduate from our public universities debt-free; raise families unencumbered; buy homes, goods and services from others; and indeed start businesses themselves to supply those goods and services.  But today the percentage of our college graduates carrying student debt has risen from 54% in 2004 to 61% in 2015, while the debt they carry has sky-rocketed from an average of $19,400 to over $29,200,[10] with many owing far, far more than that.  In per capita college graduates, we’re 43^rd out of 50 states.[11]

Let’s face it, my fellow Republicans.  In spite of our good intentions, we’re not in a position to boast to the rest of the nation how we have succeeded for Indiana.  Has reducing progressive taxation, disempowering labor, and reducing public goods and services for the poor, working, and middle classes worked well?  It has not.  Our bond rating is strong, but most Hoosiers are worse off.

America’s leading businesses are those that would not hesitate to change strategy if the times demand it.   For Hoosiers and for Hoosier Republicanism, too, change means challenge and necessity, but also opportunity.    Embrace it.

[1] “Indiana economy is running on all cylinders”, Indianapolis Star, 10 Jun 2016.

[2] U.S. Census, Historical Income Tables, Table H8, “Median Household Income by State: 1984-2015”

[3] Census Bureau: 2015 Annual Survey of State Government Tax Collections

[4] IU Bloomington Newsroom, 24 March 2016.

[5] IU Public Policy Institute, 2012 presentation.

[6] “Top Ten States with the Most Meth Labs.” Real Clear Politics, 8 April 2014

[7] The Kauffman Index Startup Activity State Trends, 2015.

[8] The Kauffman Index of Main Street Entrepreneurship, 2015.

[9] Indianapolis Business Journal 2016 Book of Lists

[10] The Institute for College Access and Success, Project on Student Debt

[11] Table 233, Educational Attainment by State, U.S. Census Bureau.

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SECOND QUARTER 2016 COMMENTS

Though it got off to a slow start, the second quarter presented a ride nearly as turbulent as that of the first quarter.  Based on an excessive buildup in inventories and continued weakness in the energy industry, and exacerbated by a relatively strong dollar and weak foreign markets, production of goods continued to slow and producer prices fell.  In turn, so too fell inflation expectations and yields on bonds.

In fact, reflecting global expectations of slow growth and continued disinflation (if not outright deflation), bond yields around the globe fell to their lowest levels in over 500 years.  Over $13 Trillion around the world is reportedly now invested in government bonds trading at negative interest rates, which is to say that large investors are willing to accept mild losses in safe, liquid investments for lack of any better opportunity.  These low interest rates combined with strength in the housing market and increasing employment to sustain advances in stocks.

At the same time, simmering discontent with slow economies and diminished opportunities reached something closer to a boil at home and abroad.  In America, this discontent on one hand translated into support for the anti-“establishment” Democratic Socialist Bernie Sanders, who has conceded to a left-of-center Democrat Hillary Clinton more calming to establishment sensibilities, and on the other hand to the more populist and less-than-calming Donald Trump, who is attacking global trade and security agreements heretofore thought by both parties to be pillars of modern peace and prosperity.

Across the Atlantic malcontented British, to the surprise both of observers and apparently even of themselves, voted to leave the European Union.   This vote was so unexpected to sanguine markets that it created the largest global two-day dollar loss in history before recovering to finish the quarter back in positive territory.

For us asset managers and our clients, suffering historic market drops but enjoying full recoveries twice in 6 months, we are reminded of Winston Churchill’s famous dictum: “Nothing in life is so exhilarating as to be shot at without result.”

LOOKING AHEAD

Both the U.S. stock and bond markets are enjoying a good year, as the U.S. economy has seemed to be on sounder footing than other parts of the world.  More importantly, as central banks elsewhere have reduced interest rates, as their currencies have weakened, and especially as a result of the uncertainties introduced by Brexit, investors from around the world have been attracted to U.S. investments for our higher interest rates in fixed income compared to those offered abroad and for our stable earnings in high quality stocks, all in a currency more likely to appreciate than depreciate in the near term.

On top of foreign investment in U.S. assets, U.S. corporations too have been supporting these prices through purchases of their shares, drawing from cash or issuing debt at low interest in order to buy back an amount over the last year higher even than they had earned, on track to produce the first annual reduction in S&P 500 shares outstanding since 2011.

Reasons for concern going forward are well known.  Consumer spending is up, but as a result of increased consumer debt and decreased household savings rates.  Though home sales are powering forward under conditions of low interest rates, auto purchases are leveling off and entering decline, having been fueled by a ramp-up of debt under looser standards.  Automobile manufacturers are now discounting.  So too are restaurants, which seem to be suffering their own recession.  In fact, subtracting the consumer, Deutsche Bank has observed that there has been no economic growth anywhere else in the economy.  Orders for long-lasting factory goods are off sharply, reflecting underutilization of existing capacity, high levels of existing inventory, and weaker foreign currencies weighing upon exports.  If the consumer turns over, the economy could enter contraction with little Federal Reserve ability to stop it.

Meanwhile, Blackstone’s Larry Fink states that between the U.S., Japan, and China alone, there is $55 Trillion in cash sitting in bank deposits, presumably in the hands of people and institutions without the desire, the need, or the incentive to spend it.

With consumer incomes still under stress, business investment still unnecessary, and immense amounts of cash sitting on the sidelines with nowhere to go, the call for increasing government spending has become ever more widespread, even the Wall Street Journal from the right joining the New York Times from the left to acknowledge a consensus among economists that “fiscal stimulus is a better tool than monetary stimulus to combat the low growth and tepid inflation that has bedeviled economies in recent years.”  Donald Trump has proposed “to prime the pump” with an increase in infrastructure spending that would add about 1% to the nation’s growth in GDP, nearly twice that proposed by Hillary Clinton, and funded by increased debt, compared to the taxes and infrastructure bank that Hillary Clinton proposes.

These calls from both major party candidates are consistent with the argument of former Treasury Secretary Larry Summers for $1-2 Trillion of additional infrastructure spending over the next ten years.  Harvard’s Kenneth Rogoff, who with Carmen Reinhart has enjoyed at least some respect from the right since they penned This Time is Different in the wake of the financial crisis, is endorsing the concept of increased spending, provided that it is directed towards infrastructure and worker training, and he endorses as economically superior the Clinton approach of funding spending with increased taxes on the rich instead of Trump’s approach of tax cuts and increased debt.  A third option of finance exists, Benjamin Bernanke’s famous “helicopter” option, by which the Federal Reserve could buy U.S. Government bonds with infinite maturity at a zero percent interest rate, never to be paid back, thus effectively creating “free” money.

IN SUMMARY

Whether by Republican or Democrat, it seems more and more likely that increased government spending is headed in our direction, which enhances the prospect of a new source of demand for the goods and services businesses have to offer.  There remains uncertainty both as to how that government spending would be financed (with different ramifications for interest rates and earnings), and as to whether and to what degree that spending would be reinforced by similar policies abroad.  In any case, while all risk must be acknowledged, undue confidence in bonds or pessimism in stocks seems unwarranted given the potential economic upsides associated with looming fiscal expansion.

*****

The thoughts expressed on this web page provide insight into the investment and/or financial planning considerations of members of C.H. Douglas & Gray, LLC, a firm providing fee-only financial advice in asset management to households and institutions in states in which it is registered. Specific investment advice is available only to clients of the firm. Contact C.H. Douglas & Gray for more information.

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Overall, CHDG received gratifying ratings and comments, with over 90% of respondents rating our knowledge of investments, the market, and the economy excellent, and 100% rating our quality of investment management and financial advice, as well as our courtesy and responsiveness, excellent or good, with a strong tilt towards excellent. We appreciated the strong scores clients gave us in meeting their needs, over 95% responding that we meet their needs extremely well or very well. We will strive always to maintain and improve upon these ratings as much as is humanly possible; it is our view that we can never be good enough.

But the object of our survey is systematically to uncover specific areas which we can target to improve upon. Though the vast majority of respondents (67%) rated our understanding of their needs as excellent, and over 90% rated it at least good, we see an opportunity to improve upon that rating. We would wish none to feel that our understanding of their needs is not thorough. To that end, we shall in the coming year revisit with all clients our understanding of their short and long term goals, assess their progress towards them, and consider together what further action would help them to attain them.

Finally, the survey also provided us with detailed insights into the value our cleints assign to our various means of communication, including our quarterly reports, our conferences, our meetings, our telephone calls, our e-mails, and our online presence, which insights we will put to use. We appreciated the many comments and suggestions, which we will hold confidential, respond to, and act upon as appropriate. The raw survey data may be found here.

We thank all very much for doing business with C.H. Douglas & Gray Wealth Management. Client referrals are important to us and we welcome them!

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We alerted the examiner to the fact that one client household was an offshoot of another client household of longstanding, but required a new signed contract, which we obtained and supplied to the office on June 8^th, 2016.   This produced the only finding the examiner issued, along with an instruction to “Please ensure that contracts are maintained for all future and current clients.”

The examination letter is available for inspection upon request.

The thoughts expressed on this web page provide insight into the investment and/or financial planning considerations of members of C.H. Douglas & Gray, LLC, a firm providing fee-only financial advice in asset management to households and institutions in states in which it is registered. Specific investment advice is available only to clients of the firm. Contact C.H. Douglas & Gray for more information.

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The significance of negative yields is truly hard to fathom. All the future value of the debt instrument is being realized in the present – there is no future value. This has tremendous repercussions for the business models of industries such as insurance or pension funds. It becomes difficult to match future long-term liabilities if today’s assets have no return. Yet, these institutional buyers are forced to continue buying securities. And seemingly the only justification that one can put forward to buy these negative yielding assets is that yields will fall further. It is a variation on the “Greater Fool Theory” (I will foolishly buy this overvalued asset counting on a greater fool to buy it from me at an even higher price).

Part of the recent strength in the equity markets can be attributable to the search for yield. Investors are purchasing stocks with dividend yields greater than 10 year Treasuries. The S&P 500 yields 2.2% versus 1.7% on the 10-year. The CFOs of companies can capture a positive spread by buying back stock financed by debt that yields less than the stock.

There is a Wall Street maxim attributed to John Maynard Keynes that the market can remain irrational far longer than an investor can remain solvent. Over the last couple years, those who have been betting that yields would rise have lost money. And remember, the “smart” money was positioned for a rising rate environment in 2016. However, at some point, unless we are in a deflationary environment, losses in the fixed income market are going to be realized. Those holding negative interest-rate bonds will realize a loss as those bonds mature. If rates were ever to increase, those losses would be realized much sooner.

Of course, while this author should be able to pronounce with some confidence that there will be losses in the fixed income market, Japan represents the counter argument. Its yields have been lower for longer than anyone could have imagined possible. And not only have they been lower for longer, but now they have slid into negative territory. Perhaps we are not appreciating the cumulative force of aging societies, deflation and slow economic growth across the globe. Nonetheless, I maintain that we will tell our grandchildren of these strange days where interest rates were negative.

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FIRST QUARTER 2016 COMMENTS

At the start of the first quarter, fear infused the market.  Yale’s Robert Shiller in his book “Animal Spirits” observes that market movements can be herd-like and produced by a mix of factors unknown.  What produced this record market drop in the first quarter?  Clearly, as earnings estimates were dropping, pessimism about earnings contributed… but earnings estimates had been dropping all along.

More likely, additional factors contributed, including on the one hand a growing consensus that the economy was weak, afflicted with overcapacity, excess inventory, a recession in manufacturing, and still meager wage growth, but on the other hand a fear that the Fed was on a path to raising interest rates.

While beneficial and perhaps even critical for the health of banks, in order to make money off of money, and for the ability of insurers to meet annuity and pension obligations, higher interest rates would be problematic for the rest of the economy.  First, they could slow the purchases of those things that are financed by debt, like houses and automobiles.  Second, and as worrisome, in a world in which half of foreign government bonds have dropped into negative interest rate territory, higher interest rates in the U.S. would attract foreign cash; boost the U.S. dollar further; make U.S. goods more expensive to foreign buyers; exacerbate America’s export challenges under conditions of an already slow global economy; make foreign goods less expensive by comparison; encourage their import and competition with domestic manufactures; create downward pressure on prices; and force U.S. companies into cost cutting modes in order to maintain margin, all of which could be both deflationary and recessionary.   In fear, the stock market adjusted to the threat.

But as might always be expected in a market economy, self-corrective mechanisms also intervened.  First, try as it might, it isn’t the Federal Reserve that sets most interest rates in the economy, but the market.  Consequently, anticipating a growing potential for deflation and recession, the market took control of interest rates…. and lowered them.  The 10-year Treasury rate fell of its own accord to levels not seen in a year, and well below the dividends paid on the S&P 500, establishing a floor for the stock market.  Who would want to own cash, paying nothing, or bonds paying 1.7% with little upside potential, when they could own a basket of U.S. blue chip stocks paying 2.3% in dividend and priced close to their long term average when compared with earnings?   If nothing else, corporations sitting on mountains of cash would increase their buy-back of shares and support prices, if retail investors would not.

Second, as a consensus developed that the Fed would not be able to act as soon or as vigorously as it had indicated, the U.S. dollar weakened, making U.S. goods more attractive.  Meanwhile, the labor market continued to strengthen, layoffs fell to their lowest levels in decades, oil prices stabilized and began to move upward, and soon the fears of the quarter diminished and stocks rebounded, dividend paying stocks especially so.   Emerging markets and foreign stocks too enjoyed a rebound.

Unfortunately, active bond managers generally failed to keep up with the whipsaw of market interest rates.  Positioned to protect against declines in bond prices (which move inversely to interest rates), many bond managers lagged in performance or even lost a little bit when bond prices rose instead.

LOOKING AHEAD

In spite of the stock market’s recovery, there are reasons to worry.  Though from a long term perspective the stock market still looks more attractive than bonds, after its rebound it is not nearly as attractive as it was at its lows in the first quarter.

Fundamentally, the economy may now present the stock market with a challenge.  After an era during which profits were at record highs in part because wages (an important part of the cost structure) were at record lows as a percentage of GDP, cash generally has accumulated more in the pockets of capital owners, whether kept in companies or paid out as dividend, and less in the pockets of the work force, who have seen median incomes decline in inflation-adjusted terms.

Worrisomely, capital owners are ever fewer.  Households have liquidated stocks out of fear or necessity as a result of the market’s turbulence and recessions since 2000.  According to Gallup, the percentage of Americans invested in the stock market directly or indirectly has fallen from 67% in 2002 to 52% in 2016.  It may also be the case that as a result of the reduction in the estate tax, capital owners are no longer as incentivized as they once were to share the rewards of capital ownership, whether through employee stock ownership plans or transfer of capital to charitable endowments (such as the Rockefeller or Ford Foundations, or the Lilly Endowment).  Today, 10% of the population owns over 80% of U.S. stocks, and 1% owns nearly 40%.  Meanwhile, the Wilshire 5000, once the benchmark of the total U.S. stock market, encompassing almost all its publicly-traded stocks, is now down to 3500 companies, and merger and acquisition activity seems likely further to reduce that number.

Objectively, the economy’s profits are becoming more concentrated in fewer companies in fewer hands.  The consequence of this concentration is that corporate profits are not recirculating as they did before back into the broader population to fuel increasing consumer buying power, but instead are accumulating in households whose needs for goods and services have long since been met.   Profits, then, are overwhelmingly saved rather than spent, and so the Wall Street Journal has reported a global savings glut.  The so-called velocity of money, a measure of the turnover of a dollar as it changes from hand to hand through the economy in the purchase of goods and services, has dropped by a third since its high in 1997, and is in a 5-year trend of ever lower record lows.

Meanwhile, the cost of education once born by the tax payer or by the charitable donor has shifted onto the student, who upon graduation is struggling to make debt payments, has no extra money to spend, and can’t get loans for other purposes.   On the other end of life, as a result of recession early in the last decade, financial losses in the wake of the housing bubble, job losses in the financial crisis, and a spend down of savings to preserve lifestyles, typical working households approaching retirement have very little to spend, for they must work longer and save that which they can manage to earn.

The picture we have drawn of compounding, concentrating profits going unspent at the top level of the economy on the one hand and a struggling population suppressing demand on the other is problematic.  For example, Walmart is projecting flat sales and is closing stores, their competitors now out of business, the profits in the local economy having been swept away, rather than returned in the form of higher wages, no more to be earned, and none to recirculate to fuel other opportunity.  In Indianapolis, Simon Property Group reports that in spite of bankruptcies of tenants, it’s doing fine, but a flat-lining economy is responsible for a 10% decline in 1st quarter profits compared to the previous year.   The fear is that with profits under pressure, cost cutting must resume, placing pressure in turn on demand, producing a downward deflationary spiral which, as we’ve seen in Japan, could be difficult to arrest.

Under the circumstances, with the Fed unable to do much more, with consumer demand under pressure, with little need for business investment in an environment of global over-capacity, and with relatively strong housing already in play, but potentially insufficient to sustain economic growth, that leaves government as the remaining sector able to contribute measurably through fiscal means.   To that end, a chorus of important voices is rising in harmony.   Paul McCulley, formerly of PIMCO and now of Cornell, his former colleague Mohamed El Erian now of Allianz, 5-star rated Bond Manager Scott Minerd of Guggenheim, famed investor Carl Icahn, Blackrock’s Larry Fink, and J.P. Morgan’s Jamie Dimon all are calling for fiscal action, by which is meant an increase in government spending financed either with debt at today’s low interest rates, taxes, or a combination of the two. It is noteworthy that even Donald Trump, who is emerging to claim the Republican nomination, is calling for increased spending on the military and on infrastructure and has declined to sign a pledge not to raise taxes.

IN SUMMARY

Elections do have consequences.  Though Congress harbors resistance, all three remaining main party candidates for the Presidency, Republican Trump and Democrats Clinton and Sanders, are now embracing both increasing wages and government spending.  The success and mix of their proposals would determine the course of the economy and of corporate profits, as would their failure.

While cash offers only future buying opportunity and no return in the meantime, the U.S. stock market now seems fully valued, with upside in prospect should the election produce greater odds of fiscal stimulus, but poised for eventual disappointment should gridlock continue.  The bond market, on the other hand, offers gains under conditions of gridlock, but potential losses under conditions of economic growth.  Because of the considerable uncertainties of this election year, diversification offers both the best potential and protection.

*****

The thoughts expressed on this web page provide insight into the investment and/or financial planning considerations of members of C.H. Douglas & Gray, LLC, a firm providing fee-only financial advice in asset management to households and institutions in states in which it is registered. Specific investment advice is available only to clients of the firm. Contact C.H. Douglas & Gray for more information.

The post First Quarter 2016 Comments appeared first on C.H. Douglas.

According to this group of strategists, no one really has a handle on the significance of what negative interest rates mean.  Negative rates completely disrupt the business model of financial institutions, which is why you have seen such a strong sell off of financial institutions since the start of the year, especially in Europe.  Further, negative interest could have the paradoxical effect of encouraging excess savings, as individuals are forced to save more to make up for the meager returns on fixed income instruments.

Negative rates, and the prolonged period of low interest rates in general, have contributed to over investment and excess supply in many areas of the economy.  It has allowed many marginal companies to continue to limp along, disrupting the normal life cycle of the economy where weak companies are bought out or enter bankruptcy.

The collapse of oil prices is a case in point.  The United States dramatically expanded its investment in shale gas and oil fields, owing to cheap debt.  This in turn led to the world becoming awash in oil and then to a subsequent fall in oil prices.  The many oil companies that used debt to fund their drilling have seen their bond prices collapse, as the market waits for a broad swath of bankruptcies.  At the same time, the low oil prices have put tremendous pressure on the budgets of the oil producing countries such as Saudi Arabia, Russia, Venezuela, and Norway.  This has led the sovereign wealth funds of these countries in turn to sell equities so that funds can be repatriated to meet the looming budget deficits.

One of the arguments coming out of the symposium is that as these junk bonds and loans connected to shale oil collapse, they will in turn effect the financial institutions that hold them and which must write them down.  This will in turn feed into the larger economy, just as the subprime housing collapse fed into the larger economy.

In general, there is concern that the massive intervention of the various Central Banks has run its course, and that fiscal stimulus needs to be introduced, although the political will to do this seems to be absent.  Economic growth is in short supply.

The thoughts expressed on this web page provide insight into the investment and/or financial planning considerations of members of C.H. Douglas & Gray, LLC, a firm providing fee-only financial advice in asset management to households and institutions in states in which it is registered. Specific investment advice is available only to clients of the firm. Contact C.H. Douglas & Gray for more information.

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Turmoil in the Markets

The stock markets globally are going through a moment of turmoil.  In our opinion, there are two primary related reasons for this present turmoil.

The first reason is fear that the global economy may be slowing, especially given concerns that the development of China, which has contributed much to global growth, may no longer have so much to contribute. The damage of a slow-down in China is felt especially on commodities, like copper, steel, iron, and oil, all of which are supplied by the rest of the world to China. If China won’t be buying as much, then producers of commodities won’t be able to sell as much, nor will companies that supply those producers with the equipment necessary to produce them.  So a slowdown can hurt even American manufacturers like Caterpillar, which supplied so much to construction in China and to mining in many other countries.  As you can see, a slow-down in China can ripple through the global economy even to jobs in America.

The second and related reason is the drop in the price of oil.  The price of oil is dropping because if the global economy is slowing, then less oil is required, especially if we have increasing fuel efficiency and alternatives to oil like wind and solar power. But at the same time that we have less need for oil, we have more of it, because the United States has been so effective at developing our own oil supply.  And more still may enter the market from Iran, which finally is re-entering the global economy with oil as its main contribution. The problem with the massive drop in the price of oil is that it means a drop in revenue for oil companies, especially those that have invested so heavily in fracking, which has contributed so much to economic growth in America. So corporate profits are taking a hit.

What we have described are global growing pains that all acknowledge.  There are others that are politically sensitive… that cause arguments around dinner tables… and so we won’t address them here, except to say that how governments around the world address their economies does influence the future.   In America, these policies are the product of a democratic process, and 2016 is an election year, so this adds to economic uncertainty.

Regarding Investment

All of these things said, how would we advise investors to react?

The first is to recognize that over the long term, the average investor often does significantly worse than the market.   The reason is that it is only after the markets have done well that the average investor too often starts buying. By then prices may be too high. Then, only after the markets have fallen, does the average investor start to sell.  By then prices may be attractive.  Consequently, the average investor is often enthusiastically buying at the wrong time and anxiously selling at exactly the wrong time. Studies now show that sophisticated investors have done well over the last decade and a half compared to unsophisticated investors because of this very reason, having recovered their losses both from the year 2000 and from 2008 while the average investor was abandoning stocks.   When the market is in its worst position is also when the market is at its most attractive.  So, though the market may yet have some downside, this is likely the wrong time to be selling.  Those with money on the sidelines with eyes focused on the long term more likely ought to be considering buying.

The second is to know that there is not just downside risk, but upside risk as well, that is, missing out when markets swing upwards.  We just don’t know what Central Banks are going to do.  For example, this morning the European Central bank announced measures to introduce more and cheaper money into Europe’s economy, and so stocks there have rallied.   If the U.S. economy seems to be losing its footing, the Federal Reserve too could announce its intention to delay increases in interest rates, or even lower them into negative territory, as European central banks have.  Either could cause a rally in stocks.   And so it seems unwise to bet that stock markets will fall further. By the end of the year, optimism could reign again, and though the markets are down now, it is not at all clear that they will remain so.  We don’t know.  (And those who say they know also don’t know!)

So for investors who are younger, it is important to recognize that drops in the market provide opportunity to invest at lower prices with a better opportunity therefore to improve long term returns.  It is counter-intuitive, but drops in the stock market are very good for you.

For older investors, it is important to have been reducing exposure to stocks all along, precisely so as to avoid the pain associated with stock drops from which you might not have sufficient time to recover.  Admittedly, this can be a scary time for older investors, for cash is earning nothing, and bonds offer little return and could even lose money, though not as much as stocks can.  Provided that you are not over-exposed to stocks, it may be helpful to know that if you are able to maintain discipline and rebalance through turmoil, once the turmoil has passed you can be in a better position than if the turmoil hadn’t even occurred.   (Rebalancing is that process of selling some of that which has done well and buying some of that which has done poorly in order to maintain a target allocation between the assets.)

In Summary

It is in the midst of market turmoil that some truly poor investment decisions can be made.   The best decision making takes place in advance, by considering your ability to take risk and endure the ups and downs of the stock market, and then positioning your investments accordingly in a well-diversified portfolio.  Then, when turmoil strikes, there is seldom a wiser policy than to maintain discipline and rebalance.

In the meantime, please do not hesitate to give us a call at 317-843-8300 if you would like to discuss your portfolio.

*****

The thoughts expressed on this web page provide insight into the investment and/or financial planning considerations of members of C.H. Douglas & Gray, LLC, a firm providing fee-only financial advice in asset management to households and institutions in states in which it is registered. Specific investment advice is available only to clients of the firm. Contact C.H. Douglas & Gray for more information.

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Below is that which we have advised our clients after the end of the fourth quarter in 2015.

Fourth Quarter 2015

Though the Fed raised rates in the Fourth Quarter for the first time in nearly a decade in the face of slow but sustained U.S. growth, the S&P 500 rose 7.0% while the Russell Mid Cap Index and US Small Cap stocks both gained 3.6%.  The MSCI Index for Foreign Developed stocks gained 4.7% while the corresponding Emerging Market Index rose slightly (0.7%), struggling against continued difficulties in China. The US Aggregate Bond Index fell 0.6%. High Yield and Inflation-Protected Bonds posted losses of 4.9% and 1.2% respectively.

FOURTH QUARTER 2015 COMMENTS

The great growth achieved by China over many years was the product of a building boom promoted and engineered by the Chinese government, and financed by poorly regulated and poorly policed debt and equity markets.  Great fortunes were made, though not well-shared. The result was massive industrial capacity constructed, but inadequate demand.  Indeed, some argue that with an increase in the sharing economy (see:  Uber) and in the use of phone applications in place of buying hard goods, China’s excess capacity may never actually get used.

China’s problems have become the world’s problems, as the temptation of all nations with excess capacity and potential instability is to lower prices sufficient to squeeze out competition, increase demand for their own products, and put that capacity to work.  As Chinese nationals nervous about their political landscape have rushed to expatriate their cash by buying foreign assets, China’s currency has fallen and America’s currency has risen.  Other governments have cheapened their currencies by lowering interest rates, most recently into negative territory in Japan.  Indeed, according to Merrill Lynch, 55% of government bonds around the world now carry interest rates of 1% or less. Downward pressure on prices continues, and inflation globally is so low as to touch upon deflation.

As the U.S. dollar has strengthened, U.S. goods have become more expensive for foreign buyers.  Consequently, exports were in decline in 2015 for the first time since the financial crisis. Even Macy’s reported slower sales in the holiday season in part because of lower spending by foreign tourists in their stores. While the service sector continued to enjoy growth and pricing power, prices of durable and nondurable goods subject to foreign competition fell for the better part of 2015, and U.S. manufacturing entered recession. It is under these circumstances that a most troubling concern has arisen, and that is in what seems to be a climb in inventory to levels well above normal and not seen since the last recession.

As the global economy has slowed, so too has the demand for oil and support for its price, an unfortunate development for energy producers of all descriptions, especially since they are multiplying.   In addition to the impact of fracking and cost-effective alternatives, the return to the market of Iran and its oil has taken place at just the wrong time, producing a collapse in energy prices and threatening the solvency of energy-producing operations and of the bonds that financed them.  As a result, high yield bonds especially suffered losses.

LOOKING AHEAD

Except when in shock, the markets are forward looking. The decline in stock market prices at the beginning of 2016 reflects a decline in estimated earnings, which in turn are the product of lowered expectations for global growth.   The damage to estimated earnings may not be over.

But it would likely be a mistake to act on a belief that stocks have a great deal farther to fall than they already have.  First, the prices being paid for those estimated earnings now appear more attractive than they have for many years, given interest rates that are low and likely to remain low.  For example, dividends on the S&P 500 are now higher than the yield on a 10-year Treasury.  Which would investors prefer to own for the next 10 years?   A bond, with no prospect for appreciation and less than a 2% yield?  Or a diversified basket of stocks with the prospect for at least some price appreciation and a 2.3% dividend yield in the meantime?

Further, there continues to be a great deal of money on the sidelines.  According to the investor Richard Bernstein, individual investors have been sellers of stocks, not buyers.  Meanwhile, corporations continue to sit on a massive amount of cash which, in a slow-growth global economy of excess capacity, they are reluctant to invest. What are their remaining options?  The companies could increase their dividends, but their largest shareholders neither want to pay the taxes nor have anything else they can do with the cash.    That leaves mergers and acquisitions and share buybacks.

Given that the world is so awash in cash looking for opportunity that cash is virtually free, Wall Street’s traditional role of selling shares to raise capital for companies is no longer the money making opportunity it once was.   Money is easy to come by, and corporations already have all they need.   Instead, as companies engage in share buybacks, Wall Street’s opportunity is in helping their corporate clients find the shares to buy.   Under such circumstances, it behooves Wall Street firms in the service of their corporate clients to induce retail investors to sell their shares, not to buy them.

And indeed, it has been retail investors selling and corporations buying.  Consequently, though earnings may not have much to grow in absolute terms, earnings per share can grow, as the number of shares in circulation shrinks.  Meanwhile, mergers and acquisitions, which last year were running at a record pace, can enable companies to achieve new efficiencies and higher profits even in the absence of broader economic growth.

Finally, no sooner might one surrender to a belief that market forces are downward than the Fed may in fear step in with new stimulus, following the lead of the central banks of Europe and Japan even into negative interest rate territory.  And market economies do have at least some important self-corrective mechanisms.  For instance, energy prices have stumbled badly, but lower energy prices put cash in consumer pockets while making attractive new opportunities that other producers can take advantage of.

IN SUMMARY

Stocks have received a pummeling and bond prices remain high.  But the world today is no worse, and is in many respects better, than it was in the years 2000 and 2008, the former when price to earnings ratios were sky high compared to today and the latter when the financial system was a giant Ponzi, both households and corporations sustained by debt.  Investors who remained disciplined recovered from both market declines and advanced.  It will remain always the case that it is in moments of fear that the best values are to be had in the purchasing of stocks. It was investors who lost discipline and abandoned ship in the midst of the storms who failed to recover.

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The thoughts expressed on this web page provide insight into the investment and/or financial planning considerations of members of C.H. Douglas & Gray, LLC, a firm providing fee-only financial advice in asset management to households and institutions in states in which it is registered. Specific investment advice is available only to clients of the firm. Contact C.H. Douglas & Gray for more information.

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