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  1. The Great Correlation Collapse

    As flat as the Kansas prairie. That’s one way to describe a volatility chart for the equity markets in 2017. Seemingly absent from Wall Street this year, volatility indexes are trading near record lows and rarely getting close to long-term averages. Our human nature likes a smooth ride, whether in a car or in our investments. For the former, we can thank good road and suspension engineers, but in the latter it is often less obvious. We should look around a bit more to find out where to direct our appreciation. At the same time that volatility has bottomed, equity indexes have hit dozens of records through the year in a mostly linear way. According to LPL Financial, the S&P 500 recently set a record for how long it has gone without a decline of 3%. As of November 14, it has gone 50 sessions without a drop of 0.5%, a stretch last seen in 1968. And for the year it has experienced only eight sessions where the closing price changed at least 1%, an unusually small number of occurrences. Nothing to see here, please move on. It seems our good fortune comes largely from the collapse in equity market correlations. Correlation refers to the degree to which two different securities, or groups of securities, move in tandem. A correlation of 1.00 means both assets move perfectly in tandem. A correlation of 0.00 means two assets move in completely opposite directions. According to DataTrek, Research, between 2012–2016, average sector correlations were 0.81; last month they…

  2. Global warming

    We lifted the title for this post from Ed Yardeni who runs Yardeni Research, an investment strategy research firm. Ed offers a checkup on an economic theory debate that has been simmering for several years in the economics community, nicely tucked away from the wider world. The crux of the issue is finding an explanation for the frustratingly slow pace of economic recovery coming out of the crisis of 2008. Emerging from the ensuing recession, the U.S. economy was forecasted to grow in the same 3-4% range as in other recoveries. We crossed 3% a quarter here and there, but overall annual growth rates hovered around 2%. Aggressive forecasts were constantly scaled back, but the answers to the shortfalls weren’t obvious. In 2013, Larry Summers, a Harvard professor, gave a speech that suggested the United States was stuck in an extended period of secular stagnation. This is the idea that our economic problems weren’t a product of the business cycle, but are permanent drags on the modern economy. The term was coined by economist Alvin Hansen in 1938 to explain the sluggish recovery throughout the preceeding decade. The core of Hansen’s thesis stated that slower population growth and a lower speed of technological progress would permanently thwart economic growth. World War II helped to change these circumstances, but a long peacetime expansion that followed put the theory on the shelf to gather dust, until now. Kenneth Rogoff, also a professor at Harvard, sits on the other side of the issue, dismissing secular stagnation as a…

  3. What are you afraid of?

    In 2016, Chapman University, a private, non-profit university located in Orange, California, produced its third annual survey of American Fears. The survey asked respondents about 65 fears across a broad range of categories including fears about the government, crime, the environment, the future, technology, health, natural disasters, as well as fears of public speaking, spiders, heights, ghosts and many other personal anxieties. The greatest number of respondents, 61%, report a fear of corruption of government officials. The rest of the top ten are represented between 35% and 41% of respondents. These include becoming victims of a terrorist attack, loss or illness of a loved one, economic/financial collapse and even fear of the Affordable Health Care Act, itself an effort to alleviate the fear of having no health insurance. That’s a lot of fear. The composition of the list also presents another perspective. Just how many of these fears can be addressed; can we do anything about them to mitigate our anxiety? For example, what can we do about corruption of government officials? Arguably, such untrustworthy officials can and should be dealt with at the voting booth. Joseph de Maistre, a French lawyer, diplomat, writer and philosopher who died in 1821 is credited with the quote, “In a democracy people get the leaders they deserve.” How about the fear of becoming a victim of terrorism? We could stay home all day in order to reduce our exposure to the unfathomably small probabilities, but that is hardly practical to help us navigate life successfully. What about the…

  4. Who is Jerome Powell?

    That was a late inning surprise. Yesterday, President Trump announced that Jerome Powell would be his choice to lead the Federal Reserve starting next February. Powell has been a Fed Governor since his nomination in 2012 by President Obama, so he is expected to garner bipartisan support in the Senate. Prior to the leaks that started last week, Powell did not seem to be the front-runner for the job – the highest odds we assigned to his becoming Fed Chair never exceeded 35%. Therefore, comparatively little was written about his past views and actions. As a Governor, he didn’t give a lot of speeches, his wasn’t the loudest voice in the room and he never dissented over 44 meetings. He appeared to be a loyal soldier. Powell would be the first Fed Chair without a PhD in Economics since Paul Volcker in the 1980’s, thus we lack a body of published research from which we can glean his likely outlooks and views. He does bring a respected body of public service and private business experience that should serve him well. Notably, markets will like the appointment for the continuity. What evidence does exist suggests he will maintain the path set by Janet Yellen in raising rates, diminishing the level of assets on the Federal Reserve balance sheet, supporting some level of regulatory rollback and otherwise doing little to upset monetary policy. He is not expected to rock the boat. Click here to see a Bloomberg article that we think does the best job of describing…

  5. The end of daylight savings.

    The idea of shifting our clocks to make better use of daylight is as old as Benjamin Franklin, who first penned the idea while living in Paris in 1784 when he noticed people used candles at night and slept past dawn in the morning. However, the notion wasn’t given serious consideration until the early 1900’s, and during World War I the first laws were passed driven largely by economic considerations. Now 70 countries have instituted Daylight Savings Time to some degree. Despite many adjustments since then, observance today in America is nearly universal, except in the case of Hawaii and most of Arizona. Arizona felt that with its hot climate, it argued that people prefer to do their activities in the cooler evening temperatures after the sun sets. Hawaii sits so close to the equator that its sunrise and sunset are consistent already and therefore has little need for extra light. Most countries located around the equator have opted out for the same reason. The theoretical arguments for DST – lighter evenings mean lower demand for illumination and electricity – have been debated at length, but it was rather hard to prove. However, when Indiana adopted DST statewide in 2006, after previously observing it county by county, researchers were able to study before-and-after electricity use across the state. In a 2008 National Bureau of Economic Research study, the team found that lighting demand dropped, but the warmer hour of extra daylight tacked on each evening also led to more air conditioning use which more than…

  6. Market Outlook – 3Q 2017

    In my opinion, it is wise to generally avoid pessimists and political provocateurs. Yes, they are right sometimes (and how they love to tell you when they are), but their stock-in-trade is to tell you how the American economic system is going down the tubes. Rather, I prefer to focus on being objective and optimistic. The American economic system is a very powerful engine. When good companies run by talented leaders grow their revenues and earnings, it can produce an impressive market environment. Equity markets posted another strong quarter. Corporate America reported earnings that met, and in many cases, exceeded our expectations. Their forward guidance on revenue and earnings growth are the center of our optimistic market outlook for the fourth quarter and into 2018. Revenue growth among larger companies still exceeds mid and small firms, but the gap is narrowing. Year over year revenue growth for large companies increased to 7.6% in the second quarter (from 7.4% in Q1). For mid-sized companies year over year revenue growth increased to 7.3% in the second quarter (from 6.0% in Q1). We see four things here. One, increasing revenue is the single best source of support for continued earnings growth. Two, there is a sizable gap between earnings and revenue growth which reveals the continuing positive effect of cost cutting implemented in past years. Three, larger companies have greater operational leverage that usually manifests itself first in a growing economy, but mid-sized firms are now starting to catch up. Four, while companies with foreign exposure have done…

  7. (Ir)Rational Behavior

    There is a Nobel Prize given for the dismal science — economics. Since prevailing economic theories seem to change with the weather, it may seem pointless to award a prize in the field. The recent award to Richard Thaler, however, is spot on. Thaler’s work is in the area of behavioral economics. Simply put, he studies the irrational behavior of humans in the way they handle their finances. For example: You have $10,000 in a savings account earning virtually nothing. Say you have $7,000 in credit card debt charging 18% interest. Logic would indicate you should tap the former to pay off the latter. Many, if not most, people do not. Why? Thaler found that people place a higher value on what they have than what they do not, therefore it seems more important to keep the cash than to part with it, even though there is future expense involved. He found that when the price of gasoline drops, many drivers switch to premium rather than save the difference. He learned that if a cab driver is having a slow day, he will work longer hours to try to make up for it; conversely, if he is having a busy day, he will quit early, even though the exact reverse would make better economic sense. You can read more here. It is well documented that when employees are offered a default choice to opt into a retirement savings plan rather than to opt out, many more join the plan, though the number should logically be…

  8. Going up?

    Interest rates are going up. In fact, they have begun rising already. Since December 2015, the Federal Reserve has raised the overnight interest rate from 0% to 1.25% through five quarter point increases. They are also signaling one more in December and up to three of four more next year. And if you take into account a coming leadership change at the Federal Reserve, these plans could become more aggressive in removing accommodation. So what does this mean for portfolios? The effect on equity securities will be muted, for a while. Equities typically like a little inflation; we are in a sweet spot between 1.0 and 2.0%. Equities also like interest rates to keep themselves in a range too. The boundaries of this range can change based on market conditions, but we are in another sweet spot there too. Rates are still low enough to encourage businesses to borrow so they can do their own investing. And they are too low to act as competition for investor capital. As rates rise these factors will change, but we think that is rather far away. Equities can exist quite happily with rates staying below four or five percent and nobody is talking about those levels yet. The effect on fixed income is more immediate and surprising, based on what you own. Fixed income prices are based on interest rates and the math that calculates your cash flows back to today. When rates go down, fixed income securities’ value goes up because your fixed cash flows are now worth…

  9. Are value stocks dead?

    How is it that stock markets can continue to hit new highs when the world is facing so much uncertainty? From the toll of natural disasters to an increasing array of political populism and saber-rattling of North Korea, nothing has yet sent markets off course. The fact is that financial factors still matter more. But when we look past the broad averages and push a little deeper, we can see asset class diversion that puts a different story behind the numbers. We have been keeping track all year of the performance gap between growth and value stocks. The former is up more than 19% while the latter has only managed a 5% gain in 2017*. Why has growth done so well while value has not? There are several explanations for the difference and there is something we can do about it. A small part stems from value’s strong performance in 2016 when it was up over 18% vs 7% for growth. Some of this is simply mean reversion. A more meaningful explanation derives from economic growth. Growth typically does better when economic growth is modest, while value typically does better when economic expectations are generally rising. Our economy is still growing at about the same 2% average we have seen since 2008, a bit of a letdown from higher expectations held at year-end. Investors put a premium on companies that can generate above average growth in any environment, which explains why technology is the only sector to exceed the overall returns from growth benchmarks. This…

  10. Finally.

    The Fed continues to un-amaze. If predictability is the key to a strong economy and strong markets, there is nothing to worry about. On the other hand, if gridlocked politicians, North Korea, miscellaneous hurricanes and a wild-card president are relevant to the economy, well, perhaps attention should be paid. Janet Yellen indicated that a rate hike, probably .25%, will come to pass in December with more to follow next year. She also said that the Fed will begin unwinding its balance sheet now, initially by not purchasing new securities as old ones mature. This will remove $10 billion a month from the balance sheet in the near term, gradually increasing to $50 billion a month within 12 months. Depending on how closely this plan is followed, returning to pre-2008 levels would take something over ten years, although we don’t know what the final level will be. A lot can happen in ten years. We are almost ten years removed from the problems that led to low interest rates and quantitative easing in the first place. The beginning of World War II to the beginning of the Cold War took less time. The smart phone is just ten years old. Within ten years of President John F. Kennedy telling the country we had the resources and talents necessary to land an astronaut on the moon, we did just that. Perhaps all will go smoothly for the Fed and the economy, but it probably will not. An asset reduction plan has never been tried by any Central…