Last quarter’s Insights, was titled “Pick Something and Sell It”. It was version 1.0. So why would I call this quarter’s 3.0 having not published 2.0? It felt appropriate to title it that, because this is the third iteration of the Fed’s dramatic bubble-blowing technique: 2000 (1.0), 2007 (2.0), 2018-19 (3.0).
I hope that your winter is going well. I am going to attempt to be as straight-forward and simple as I know how to be. And I’m going to try to use the simplest charts and examples to communicate this quarter.
Picture above nearing sunset at Lake Lanier January 2018 behind the boat
Why 3.0? Isn't the third time a charm? 2000 (1.0), 2007 (2.0), 2018-19 (3.0)…?...
“As we saw in 2000 and again in 2007, these new types of cycles, so dominated by borrowed money and huge asset inflation, have resulted in a personal savings rate being wound down all the way to under 3%. This is classic, late-cycle stuff.” David Rosenberg – Chief Economist – Gluskin Sheff – January 16, 2018
“It wasn’t mortgages this time around, as much as government debt, companies buying back their stock with borrowed money at an unprecedented rate, subprime autos, C&I loans, student loans, and a wild credit card spree that has taken outstanding balances well above $1 Trillion, the same size as subprime mortgages in the late 2000s.” David Rosenberg – Chief Economist – Gluskin Sheff – January 16, 2018
"In short, the world economy is now extended on the far edge of a monetary bubble that has been four decades in the making. ...Democratic policies will turn increasingly ugly, strident, and nationalistic in the face of chronic fiscal crisis, recession and quasi-recession, middle-class austerity, and bubble opulence among the 1 percent. It will result in protectionism, currency wars, and anti-capitalist policy interventions, including capital controls, punitive taxation of the "rich" (which few will actually pay), and endless bailouts and boondoggles." author: David Stockman (former budget director for Reagan Presidency) - from The Great Deformation - The Corruption of Capitalism in America.
Get your coat
We are late in the economic cycle. This is not the start of a new economic cycle. It doesn’t mean that reported earnings and repatriated dollars and buybacks don’t help the U.S. stock market continue to melt higher. It just means it’s the ninth inning of a baseball game. Couldn’t we go to extra innings?
Former Atlanta Braves announcer, Skip Carey, used to call extra innings “Free baseball.” There’s NO free lunch in investing by the way…Shouldn’t you be aware that it's the ninth inning and not the first inning and invest accordingly?
We have one of the most expensive U.S. stock markets in all of history on our hands and your starting point matters in terms of your forward-looking performance.
Most clients have enjoyed some nice stock gains to date and bonds have performed great, but how can we rationally project future returns to be the same as historical returns when asset valuations are as ridiculous as they are becoming? This is also why we’re been investing internationally in equities for some time now because some places the valuations are cheaper and they’re earlier in the economic cycle (say the 5’th or 6’th inning of the baseball game), than the U.S.
Practical investing world view
So the Fed has thrown everything including the kitchen sink at inflation and nearly ten years into the cycle hasn’t been able to sustain their stated inflation target for more than a month of two of 2% on the PCE Deflator index which is intended to measure consumer price inflation. That is changing, though, even their own measures of inflation are rising and they may finally be close to target now. Ok – that’s fine. But I submit that financial asset inflation, on the other hand, has been off the charts. Commercial real estate prices, stock prices, and even prices of used pickup trucks have been on fire, though. Plenty of inflation there and in San Francisco & Seattle residential real estate prices, paintings, etc.
Real world asset inflation bubble example:
This morning I dropped off my 14 year old vehicle that’s still in great shape, it just needs some maintenance. I always enjoy having a conversation with the gentleman that gives me a ride to the office from the repair shop. He told me that the local Jeep dealership (that sells a ton of Jeeps), has a Jeep Wrangler out in the front with a price-tag of $77,000! You read that right. It’s got LOTS of nice accessories and cool gadgets and pretty stuff, but it’s still a Jeep Wrangler and it’s $77,000! I went to their website to peruse around and see what type of Jeep Wrangler I could get for $40k. It’s pretty nice but pretty basic. So what’s gonna happen when the recession occurs (and it’s closer than people think), and that Jeep payment invoice (that’s the equivalent of a mortgage payment), comes in the mail but Mr. Jones (dad), just lost his job? With the unemployment data as positive and incredible as it is, people can't imagine it going the other way (like it always does in cycles). I think it’s either getting put in the driveway with a For Sale sign, or it’s going back the ugly way. The household incomes in this country are NOT keeping up with the kind of borrowing binge we’re seeing from the debt-addicted US of A. Even with the minimum wage and wages in general going higher. I don’t know when this movie ends, but it ain’t gonna be pretty.
Being a net seller of risk rather than a net buyer of risk
I have been reducing much of our exposure to consumer discretionary stocks. It was really, really hard to do, but I sold our Cracker Barrel stock some time back. Parenthetically, here: I LOVE Cracker Barrel. I think it’s a great place for a person who is from the country (rural background). And for city folks who aren’t, they get to see farming implements mounted on the wall in a way typically reserved for Old Folk Heritage Museums. How much you pay for something matters, though. Just because you CAN buy it doesn’t mean you SHOULD. Price paid matters a lot.
Look folks are still going there – it’s hard to find a parking place, I know! But hey - the stock’s too expensive. Remember the OLD adage, Buy low and sell high? That thinking is SO yesterday. I know…
OUR STRATEGY FOR 2018
"Ok, Jack – I think I’m understanding part of your worldview – but what’s our strategy? What are we buying and selling and holding?"
Our clients are predominantly pre-retired and/or retired and most of their peak earnings years are in the read-view mirror so they can’t afford to lose 30%-40% of their net investment asset value. That’s why we are so overweight the RIGHT bonds and have around 10% cash in accounts at present. We’ve participated in much of the run-up of equity prices with certain risk positions, but certainly not as much as some.
'The RIGHT snowman' investment positioning
The picture below looks like a snowman that toppled to the right.
We are reducing our equity exposure in companies that have a sharp, cyclicality of earnings by selling stocks like Alcoa, John Deere, Consumer Discretionary iShares, Materials stocks, Home Depot, and cutting our weightings by 50% in Cisco Systems, and Applied Materials (this is a sample of some of the names we’re reducing, not comprehensive and some don’t apply to certain households where the risk tolerance dynamics are such that the clients don’t own these names);
Adding selective short-term, AAA-rated, non-callable, municipal bonds;
Raising overall cash balances and taking profits where appropriate in stock investments;
Being focused (have been for some time now), in places like Japan, and Europe (namely Germany and France), and also New Zealand due to where they are on the economic cycle (mid-stage), versus U.S. (late-stage);
Already trimmed corporate bonds that have had credit metrics deteriorate and that may run into refinancing trouble in the near term and focused on quality (but not in the Investment Grade space (many of those bonds are trading with bubble-like valuations));
Emphasizing Value over Growth because price/sales ratios on growth stocks are way, way out of line;
We are emphasizing value over growth. (Above) The blue line represents Russell 1000 Value and the white line represents Russell 1000 Growth
I’ve reduced GE for folks that own it to no more than 1.5% of any account because yikes, it’s a tough time to get single-stock concentration wrong in 2018 and also, I really don’t like it when debt becomes an issue (or at least called into question), at a company like G.E. The numbers are staggering and frankly could sink the ship. On the other hand, if a plan is put in place like the one at Teva Pharmaceuticals, the stock could be a long-term buy at these levels. In the era of such severe financialization, leverage has been so over-used that we probably don’t really know the potential damage to G.E. yet. Only time will tell.
Let’s play defense like the University of Virginia Men’s Basketball team plays defense
Let’s play some Defense with some of our risk investments and go FROM consumer discretionary stocksTO consumer staples bonds all the while going up the corporate capital structure from speculative stocks to senior debt (bonds) (Reduce portfolio risk)
The blue line on the chart above is the stock price of Cracker Barrel Restaurants. The red line represents boring, little-old Ingle’s Supermarkets. Now please note I am not investing in the shares of Ingle’s stock. I am investing in Ingle’s bonds (for some clients).
Ingle’s Supermarkets Corporate bonds pay you 6% per year for 5.5 years.
Your order to your waiter, “I’ll have [Blank] thousand dollars of Ingle’s bonds, please. Oh, and sell my Cracker Barrel stock, too, btw. Thanks.” (For what it’s worth we used to own Cracker Barrel and don’t any more. We never owned Ingle’s stock (only the senior bonds) I just wanted to illustrate a point here)).
Start to notice XPO Logistics on the highway (you helped build that!)
So the next time you’re traveling and notice a tractor trailer on the highway that says, “XPO Logistics”, note that your CNF bonds are the old Con-Way trucking that XPO now owns. Those bonds are non-callable for 16 years and where we bought them for almost all of our clients they’re yielding 10+% per year! That’s one of the reasons what my credit analysts and traders and I do matters. Bond ETFs can’t do that.
Remember Income Now & Income Later?
If you're a client, or an investor considering becoming a client, you may have heard me say, "Income Now & Income Later". You see, with those two things securely in place, you can live in the world you wish to live in now and in the future. When I first started preaching this sermon in full earnest, almost no one believed me that we would get to this place of low interest rates globally and that we'd be here this many years later. You see, it's easy to say it now, but I can assure you, it was a lonely place back then and literally no one believed me. Let's have discussions about risk management for your portfolios and if you're new to our process, and let's get you up to speed on how to invest and get nice yields despite this low interest rate world. Helping you to understand Income Now and Income Later principles in investing will help you to sleep soundly at night.
Reckless Fed 3.0 – Raise rates, Mr. Chairman (NOW, please); I think he may… a LOT btw…
The point has ALWAYS been to bring about the “Wealth Effect” felt by the consumer, by the Federal Reserve. Remember the old Al Michaels (one of a kind sports announcer), announcement during the 1980 Olympics USA Hockey team win over the former Soviet Union? “Do you believe in miracles? Yes.” Well Bernanke/Yellen have pulled of the miraculous. I have a question for investors? “Do you believe in cycles?”
The "I'm Rich!! - I'm Poor!!" Chart
The consumer is still 70% of the economy so does this chart matter?
When people feel "poor">BUY LOW; when they feel "rich">SELL HIGH
Now what’s Jay Powell (new Fed chair), and team gonna do…?...
Jay needs a 5% cushion
Brookings in D.C., hosted a panel with Bernanke, Williams (San Fran Fed who is being considered for the Vice Chair job), and Former Treasury Secretary Larry Summers, and academics and the irreducible minimum that Summers pointed out was that the new Fed chair needs a 5% cushion on the Fed Funds rate (or the equivalent stimulus tool), before entering the next recession. How’s he gonna get that without raising the Fed Funds rate up to 5%? They’ve communicated that the approximate terminus point for this cycle will be 2.75%. I think they'll move their expected terminus rate higher in coming meetings. I am not convinced they'll be able to actually pull it off without the economy going into recession before they're through. December 2017 marked the two year anniversary of the rate increases. Historically, the increase periods last around two years, so I guess we COULD continue on an elongated duration, we just have not seen that before...
Be prepared for a Hawkish Jay Powell
I think investors and portfolios need to be prepared for what could be a policy misstep by the new Federal Reserve by raising rates too much in an effort to reduce excessive risk-taking. This would actually be a good thing and would help pricing volatility to return to markets so that investors are then being compensated for the commiserate level of risk they’re taking. But it would hurt because the markets are not currently priced for this outcome. Example: Investors that own Tesla Corp bonds off of the initial offering (WE DON’T), received sub-4% on a bond and it should’ve been in my estimation, around 12%. That’s ridiculous.
Owning solid, dependable bonds at the right prices with the right coupons and with the right credit metrics, not overly leveraged and too complicated of a capital structure, higher overall quality, good operating margins, and an ability to refinance in the next cycle is gonna save investors’ behinds. Unfortunately, most advisors with clients in bond etfs and bond funds are not gonna know what to do if the Fed raises rates too much and or we have a credit event (s), that causes volatility to spike and spreads to widen and their clients start to lose money, I think they’re gonna sell because they don’t know what their strategy is. I am sure that’ll happen to stock funds and etfs, but I also think it’ll happen with bond investments.
The Forthcoming New and Improved Federal Reserve Monetary Policy Methodology?
A few things I’ve learned recently that warrant passing along to clients and folks considering becoming clients:
- It’s likely that the Fed should adjust their price inflation target down to 0% instead of 2%;
- The “real” Fed Funds Rate is around -3.75% at present even though it’s technically at 1.25-1.5%;
- Had the Fed started raising around the July 2012 timeframe (I’ve said that many times before since before that timeframe), instead of waiting until the end of December 2015, they might not be in the mess they’re in;
- Debt bubbles are due to come under severe pressure in the not too distant future;
Still believe Lower for Longer (interest rate levels)? YES!
These forces listed below will keep rates down for a long, long time. Full stop.
Demographics (Aging of Americans)
Debt (Shocking overall amount)
Consumer inflation expectations
Debunking bond myths
Bill Gross and Jeff Gundlach are really bright individuals. I can’t, however, for the life of me understand (unless they’re somehow talking up their books), why they come out and say things like, “The bond bull market of 35 years is over”. We are having a yield spasm, certainly a cyclical bond bear market within a greater, longstanding SECULAR bull market. This simply means that Treasury yields are not set to sky-rocket. Even if they were to, we are not invested in them at all. We own corporate and municipal bonds with high coupons at reasonable prices. At this late stage of the economic cycle, PLEASE don’t let these blowhard guys make you worry about the bonds you own IF YOU ARE A CLIENT. If you're someone else's bond client, I can't say. You wanna know why? Because the demand for what we own is incredible. Time will prove that these guys are wrong.
The head of the snowman can send you checks every month. And the math is compelling vs what the capital markets will provide
Certain, Fixed Indexed Annuities (positioned as private pensions)
In closing, Discipline saves your financial life
The inexperienced sales people in our industry are getting really, really cocky. That’s a reason for concern that will very soon morph into a strong sell signal for certain investments. We’re actually probably there right now. That’s why we’ve been selling favorite stocks like Atlanta based Home Depot. It’s a phenomenal company, but gee whiz. I’ve never seen it SO expensive.
If you don’t have investment discipline, you get caught up in painful herd investing behavior and it can literally cost you a decade or more worth of savings and earnings.
This is an adult business for humble people.
I’ll stop here.
Thank you so much for your trust and your business. Have a great Winter and Spring! I have a great job and people like you make it possible!
President and Chief Investment Officer
Vickery Creek Capital Mgmt., LLC
This is a picture (below), of our dog Scooter taken after a recent snowfall by my daughter
PS – this edition may serve as a ‘double issue’ as the next edition of Insights is likely going to be published in July 2018.
Sources: Bloomberg, Brookings Institute, Reuters, Blackrock, The Economist, JP Morgan, Wall Street Journal, Gluskin Sheff, Haver Analytics, Google Finance, Federal Reserve Banks of: New York, St. Louis, Atlanta, Richmond, Cleveland, San Francisco, Kansas City, Fidelity Institutional Wealth Services, Hedgeeye, American Equity Investment Life Holding,Trading Economics, The Great Deformation - The Corruption of Capitalism in America - David Stockman, University of Virginia Men’s Basketball, Vickery Creek Proprietary Research