Recently, many investors and market pundits have been looking at the term structure of interest rates – also know as the “yield curve”- as a source of concern for equity markets. In the attached chart, courtesy of Ed Yardeni, one can see why: in many instances yield curve inversions have indeed been precursors to market sell offs. Of course, there have also been instances where inverted yield curves did not result in market sell offs. The key is the spread. At a positive 100 bps spread between Fed Funds and the 10-year note, the yield curve remains upwardly sloped and would clearly be in the territory that historically has allowed for a continuation of bull markets. A better question, perhaps, is why did the curve invert in the past? In ’73 and ’80 the Fed was tightening to curtail sharply increasing inflation. In ’99 and ’07 the Fed tightened to reduce “market excesses.” In those instances, Fed moves did lead to credit crunches which were the primary reasons for the subsequent market sell offs. However, if today’s yield curve moves were signaling a credit crunch, high yield spreads would be widening out sharply and they are not. They have barely moved all year.
Any credit spread widening we may be experiencing is more a function of increased credit demand in a strong economy, which have written about recently. In fact, per Federal Reserve data, commercial and industrial loans increased by nearly eight percent in the second quarter of this year and total credit expanded over three percent. Does that sound like a credit squeeze?
Lastly, European and Japanese interest rates remain at extraordinarily low nominal levels and at negative real rates. Among developed bond markets, the US is the only game in town. For global investors, a strong US economy and our high interest rates are very compelling. So the dollar strengthens, monies flow into longer term US government debt, and the yield curve flattens.
We believe when you look through the headline, thoughtful investors will see a flattening yield curve as a by-product of a strong domestic economy and a rate normalization process by the Fed; in isolation, it is not a factor that would cause us to change our otherwise bullish viewpoint on US equities.
We are at the point in the calendar when the “mid-year market overviews” start to appear, fast and furiously. The theme this year has been how dominant FAANG stocks (Facebook, Amazon, Apple, Netflix and Google) have been in S&P 500 returns year-to-date. The following post is typical of what has been peppering our Twitter timeline recently.
And then there was this story last week from CNBC.
You read this, seemingly every day, and you wonder why anyone buys anything else but FAANG. While it makes for a fun headline, and an interesting two-minute segment on CNBC, the reality of course is different.
Netflix (until yesterday) and Amazon have indeed had spectacular runs in 2018, up 106% and 55% year to date respectively as of July 13th, and while they are the second and eighth best performers in the S&P this year, 99 other stocks have outperformed Facebook, 104 have outperformed Apple, and 129 Google in the same time frame. What’s our point? You don’t need to own FAANG to outperform.
More importantly, in spite of the FAANG headlines, correlations between stocks are now at their lowest level in almost a decade, and investors need to properly evaluate the implication. We are moving into a period, likely to continue for some time, where stock picking has been and will be the most important characteristic if one wants to outperform benchmark indices. How do we know? We have three portfolios that own no FAANG, and those portfolios have been miles better than their benchmarks (and the S&P 500). A fourth, which owns a teeny bit of FAANG (just two of the five names) and which uses the S&P 500 benchmark as its index, is also beating the S&P 500 by a wide margin.
As of Friday, July 13th, the S&P 500 Index is up 5.86% for the year-to-date period. But, 244 of the 500 stocks in the index have lower year-to-date returns than the index and more than 200 actually have negative returns. This should tell you that portfolio construction matters. Most everybody has a spice rack in the kitchen, how it is used is up to the chef.
While stock selection has been a hugely important factor aiding portfolio performance this year, it is not the only one. Asset allocation has also mattered. Growth continues to outperform value, small stocks have outperformed large, and stocks have outperformed bonds by a wide margin (which is not as obvious an outcome as you think. . .). While the S&P 500 is up nicely this year, its small stock cousin, the Russell 2000, is almost 2x better. Also, the U.S. has clearly been the place to invest in 2018. The MSCI All-Country-World-Index is only up 1.92% and the MSCI Emerging Markets index is down 5.66%. The Barclay’s Aggregate Global Bond Index is down 1.41%, and gold is down 4.11%.
We continue to believe the period recently passed, where passive investment vehicles outperformed their active peers, will prove to be the anomaly. We have written in the past about the problems with ETFs https://midwoodcapital.com/problems-etfs-part-ii-junk-trunk/. The return performance laid out above also frames the issue with passive investing.
We started out this piece saying one doesn’t need to own FAANG to outperform. The table below is two media stocks. One (NFLX) is a media darling that everyone talks about and the other (WWE) is an old-world media company that no one talks about. The latter quietly executes relentlessly well. We own the latter. You don’t need to own FAANG to outperform. As the bull market matures, stock picking and asset allocation become all-the-more important.
Over a year has passed since the election of Donald Trump. It’s been a fascinating period in political circles and, according to CNBC, in investing markets. But has the market really been that interesting? Profitable, no doubt, but from a price action standpoint, there’s not been much to report – the market just chugs along, seemingly going up almost every day. In fact, since the election through Nov 30, 2017, the S&P 500 has risen 155 of 266 trading days and has not had a losing month since before the election. Over that time the market’s greatest one day gain has been 1.4% and its greatest one day decline has been 1.8%. Even more remarkably, we’ve also not had any sort of a meaningful correction whatsoever. The largest peak to trough drawdown has been 2.8% which occurred from the beginning of March to mid-April.
Given all that, market volatility, as measured by spot VIX, was at its highest just prior to the election and has hovered around 10 with notably few spikes since then.
Boring, but we’ll take it.
As they often do, many market prognosticators are forecasting pending doom. Yet, these forecasts are more shrill than usual as the distractions (very often caused by the President himself) from Washington are seemingly indications that the current environment cannot continue and a major revaluation of equities is imminent. A representative sampling of headlines follows:
“Why the Trump Bump Has Set Us Up for a Market Crash” – Fortune Magazine, Mar 7, 2017
“The Stock Market Has Been Magical. It Can’t Last.” – NY Times, Aug 19, 2017
“I Cannot for the Life of Me Understand Why the Market Keeps Going Up” – Mike Bloomberg, Sept 20, 2017
“Waiting for the ‘Trump Slump’ in the Stock Market” – The New Yorker, Oct 18, 2017
Yet the market continues to rise. But why? In our opinion, the answer is relatively simple: pure, unrepentant economic growth and profits. Yet it’s not just the U.S. enjoying an improved economic growth trajectory – it is a global phenomenon. Unlike a couple of years ago when several economic regions were struggling, Europe, Asia, and the Emerging Markets are all now experiencing enhanced growth rates with low levels of inflation. Even notable non-growers such as Japan are experiencing faster rates of economic activity.
Can we put the secular stagnation arguments to bed, now?
A resurgence of constructive fiscal policy initiatives both in the US and abroad are now offsetting some of the “structural headwinds” that previously impacted the global economy. Regulatory reform )in the US) has been in full swing for nearly a year now impacting a wide range of industries and sectors. (Details of various regulatory initiatives can be found here.) Year to date through September 30th, deregulatory actions have outpaced new regulations by a ratio of 22 to 1, with an estimated economic benefit of nearly $10 billion. And it appears as if this trend is just beginning.
More recently, and most importantly, the Trump administration passed a tax reform package which will have sweeping effects on rationalizing and simplifying the US tax code, creating a more competitive landscape for US corporations. And yet again, this is not exclusively a domestic phenomenon. Globally, policy makers will need to respond to this change in US tax policy in order to remain competitive and you are now starting to see evidence of precisely that.
You can have “green shoots” in tax rates too!
So, we would suggest the doom-and-gloom crowd may again be wrong. The combined effects of tax and regulatory reform, which have clearly benefited the economy and markets for over a year, can continue to have a positive effect on commercial activity and ultimately risk assets.
At Crow Point Partners, we evaluate several key economic and investment variables to determine the attractiveness of the economic environment and whether we believe that investors will be compensated for taking risk. Overall, right now, we believe that the economic and investing environment will remain attractive in 2018 and we have maintained aggressive risk postures in the portfolios which we manage.
Crow Point Global Macro
2018 1Q Key Economic and Investment Drivers
Risks are always present and the current environment is not void of them, in spite of the generally favorable backdrop. Any variable that diminishes the positive feedback loop of constructive policy, improved economic activity, increasing profits and ultimately rising stock prices is something to be taken seriously, particularly at today’s lofty valuations. In as much as an improved fiscal environment has created this virtuous cycle, politics and policy makers do represent the biggest visible risk to investment markets. Could we be one big geopolitical event away from a meaningful correction? Always. But, the current administration has been making it clear it is a friend of markets and the US economy. Until global economic growth and the animal spirits that are clearly in evidence show any signs of reversing, we remain long risk assets and expect markets to grind higher.
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