| 12 Mo.
|10-yr Treas. yield||3.06%||2.85%||+0.21%||2.33%||+0.73%||+0.66%|
|Fed funds rate||2.0-2.25%||1.75 -2.0%||+0.25%||1.0 – 1.25%||+1.00%||+0.75%|
(stock indices are before dividends; yield and rate changes are absolute changes)
The US stock market regained steam in the quarter with the S&P 500 having its best quarter since the fourth quarter of 2013. Market leadership shifted a bit from large tech to healthcare and industrials. The US dollar remained strong but international stocks eked out a small gain nonetheless. Global oil prices surged to four-year highs above $81, with US prices about $10 lower, which helped keep gas prices from rising too dramatically. The benchmark Treasury flirted with its seven-year high of 3.12% before drifting lower (and then spiking back up again right after the quarter ended).
Although new jobs in September were off, new jobs for July and August were revised upward and unemployment dropped to 3.7%, the lowest since December 1969. Monthly new jobs are running at 200k this year, up from 182k in 2017 and wage growth is finally showing some life, up 2.8% YOY. Continuing unemployment claims hit a 45-year low, indicating that people are able to find jobs, and job openings are at a record high. The participation rate for workers between 25 and 54 hit a 10-year high.
Consumer spending was steady and core inflation was in line with the Fed’s 2% target. The savings rate, reflecting the growth in wages and income, was 6.6%, a welcome sign that perhaps consumers are managing their finances more wisely. Not surprisingly, consumer confidence hit an 18-year high, also driven by the job market. Home prices continued to increase at a higher rate (around 6%) than wages and the combination of higher prices, low inventory and an increase in mortgage rates (hitting an average of 5% after quarter-end from 4% a year ago and 3.5% in 2016) is beginning to slow home sales, particularly in high-cost areas like the Bay area and southern California were down more sharply.
The final GDP growth for the second quarter was 4.2%, the best in almost four years. Trade added 1.2% to growth on stronger exports but as tariffs have been layered into place that activity could change going forward. The overall trade deficit for 2018 through July was up 7% from 2017 and was the highest in ten years. As expected, the Fed raised rates for the third time in September and another increase is expected in December. The Fed comments dropped its “accommodative” approach, indicating the Fed has moved from stimulating growth to focusing on inflation and full employment. The Fed’s GDP forecast for 2018 was increased to 3.1% from 2.8% (and it was 2.5% at year-end 2017).
There was a shuffle in the 11 sectors that make up the S&P 500, with media and search companies like Google and Facebook moved into an expanded Communications Services sector and Ebay moved from technology to Consumer Discretionary. Overall, Technology in now less than 21% of the S&P 500, down from over 26% before the changes. Both Apple and Amazon hit the $1 trillion market value mark, although Apple continued to rise while Amazon drifted lower after its intraday peak.
On the international front, Greece ended its third and final bailout round and is now “on its own”, ending one of the last lingering hangovers form the recession. The US and Mexico reached a “new NAFTA” accord with Canada signing on October 1, creating an agreement that is largely similar to NAFTA but with some procedural changes and rules that will impact specific producers such as autos and dairy.
It’s nice to note upcoming events that will mostly be resolved in the next six months to a year. But economic trends often take a long time to develop and the impact can take longer to recognize as well. Overall debt levels have been gradually shifting through the recent low-interest rate years and the long-term consequences could be significant.
The consumer is not the biggest debt worry. Total household debt hit a new high around $13.3 trillion in the second quarter of 2018, a quarterly increase of $82 billion, with $9 trillion in real estate debt. But with the increase in home prices homeowner equity (the difference between what is owed and the market value of the house) is at an all-time high. Borrowing against the equity in a house is also holding steady despite growing efforts by lenders to drum up interest; maybe individuals have finally learned that spending the value of a long-term asset like a house on short-term indulgences is not a good idea. Yes, student loans have grown dramatically, from $508 billion to $1.5 trillion in the last 10 years, and delinquencies have also continued to grow to over 11%, but only a policy change seems able to make those loans manageable.
Government debt remains a problem. It is technically possible that increased growth could increase government revenues to offset additional federal debt, but that chance seems remote. The bill will come due and significant changes to revenues or spending or both will have to be made. At the state and local level, unfunded pension obligations are a growing burden and some states are looking to “pension bonds” as a solution. This is really just a bet that the states can earn more from investing the bond proceeds than they are paying in interest, and that seldom works out.
Corporate debt is the main concern. Corporate borrowing has increased nearly 75% to $8.4 trillion, with some of that fueled by private equity firms buying companies with debt. Maturities have gotten longer and credit quality has slipped. High yield (junk) bonds have grown to 22% of all corporate debt and BBB debt, the lowest level of investment grade, is by far the largest area of non-financial company debt. The problem is not isolated to the US, with China’s corporate borrowing growing to $2 trillion in just 10 years. These loans have displaced bank loans and shifted the risk from the government to investors.
All this debt may be actually be repaid. But even relatively small defaults will begin to erode confidence in all this borrowing and things could turn sour in a fast, and scary, way.
We became familiar with another financial planning firm that created an in-house mutual fund to implement its investment strategy. By placing part of clients’ portfolios in the fund they were able to more efficiently make portfolio adjustments without having to do so for each client. Seems like a great idea.
Unfortunately, the fund has been ultra-bearish for the last eight years, and while protecting investors from loss is a worthy objective, the fund has completely missed the gains of this bull market. It has made extensive use of futures which are supposed to be negatively correlated with (that is, moves differently than) the stock market but that in practice are extremely volatile. The fund had a large position in another unaffiliated fund that bet the market would continue to have low volatility and that other fund imploded in January 2018. And the fund’s annual expense ratio is a very high 2.9%.
The strategy of this fund violates all our fundamental principles of portfolio management. First and foremost, we seek to do no harm to our clients. That categorically does not mean that a portfolio will not suffer any losses because we accept that long-term growth also requires the acceptance of market fluctuations. It does, however, mean that we do not use complicated investment vehicles to try to avoid market movements because these vehicles and strategies invariably either blow up or have losses that offset any possible benefit from their use.
The second principle is to add value. Again, this does not mean that we have some magic that allows us to “beat the market”. Rather, it means that other portfolio management responsibilities beyond the initial portfolio construction (maintaining discipline during market declines, raising cash as needed, rebalancing and portfolio and fund monitoring and evaluation) avoid the emotional decisions to either make inopportune changes or to take no action, both of which can prove very costly.
The third, and most important, principle is to implement portfolio strategies that support client goals. Those goals are based on career aspirations, lifestyle choices, family issues, and, yes, dreams. By explaining how the portfolio is constructed and how the pieces are intended to work together, clients quickly come to understand that we are working with them to help them reach their goals. And when markets get rough, referring to those goals provides the context and perspective to soften their anxiety.
As financial planners, our portfolio construction and management are driven by the other planning issues and clients’ risk tolerance rather than “leading” the whole effort. It’s not sexy but not only are we confident it’s the best way to get the job done, our clients’ experience confirms it.
Milestones or Distractions?
There were several milestones this quarter that garnered a lot of attention.
• Apple was the first company to reach, and then blow past, a $1 trillion market value. Amazon hit the $1 trillion mark in intra-day trading before sliding back a bit.
• The NASDAQ hit 8000 and kept going.
• On August 22 the current bull market in US stocks hit a new “record” of 3,453 days since the market low on March 9, 2003.
The first is the easiest to digest. Damn, $1 trillion is a big number!! But the market value of any company is influenced by many factors, including the overall market, “momentum” investors who push rising stocks higher and the capital structure of the company, that is, how they want to manage their use of equity and debt. Any particular market value is irrelevant to an investor whose gains are entirely dependent on when the stock was bought, not on its overall market value. Denis did an excellent blog on the history of the highest-valued US stocks (https://gordianadvisors.com/trillion-dollar-babys/) and that title has been won, and lost, by many companies over the years. Apple is financially strong and has great products but its dominance will undoubtedly fade as well. The arbitrary $1 trillion mark is inconsequential.
The 8000 level for the NASDAQ is similar. These arbitrary milestones provide a simple reference point but as the market rises, each subsequent 1000-point increase is a smaller percentage gain. Coincidentally, the NASDAQ level is largely driven by Apple and other large tech firms so these two are really just looking at the same market forces through different lenses.
The length of the current bull market does warrant some further examination. The “record” is based on the length of time since the market, as measured by the S&P 500, has been going up without experiencing a decline of 20%. the traditional measure of a bear market. The S&P 500, with some bumps along the way, has increased over 320% since the market bottom in March 2009. Long-term investors should be elated.
This may, however, just be a case of selective measurement. While the S&P 500, which is an index of mostly large company stocks, did not drop 20%, broader market indices which include large and small company stocks did drop 20% in October 2011 when the market swooned in the wake of the credit-rating downgrade for the US government and troubles in Europe. Not only that but based on intraday prices instead of end-of-day closing prices, the S&P 500 itself was down 21.6% in October 2011. (Based on closing prices, the S&P 500 was down 19.4%.)
Using a consistent “closing price” approach, there was not a bear market for 13 years, from 1987 to 2009, for the S&P 500. The bear markets in 1990 and 1998 were both based on intraday prices. And then there is the “secular” bull market which is based on longer trends and can absorb a short-lived bear market. Since 1926, the typical secular bull market last 8 ½ years but they can last as long as 20 years or more.
The real question is whether the economy is positioned to support continued growth and hopefully further market gains. The last two bull markets ended with the bursting bubbles of tech stocks in 2000 and real estate in 2007. The discussion of debt in Looking Forward notwithstanding, there does not appear to be an obvious bubble on the near horizon. Of course, these things have a way of sneaking up on everyone and snowballing quickly, so there is always the risk of a major downturn.
We can say with certainty that this bull market will end, and there will more than likely be a market decline of greater than 20% across the board. But when, why and to what extent this will happen is impossible to predict, so in the meantime manage your overall risk by incorporating the impact of market declines in your long-term financial plans.