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investevergreen-blog · 10 years ago

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MARKET OPPORTUNITY

More of the same as pendulum swings to irrational fear, providing solid opportunity for patient investors willing to rise above emotion. Are you willing to rise above? Are you ready to harness the power of long term investing?

As expected, volatility has continued in great force within the markets. Fear continues to run rampant and many emotionally driven investors are making some very poor long term moves. Having been through this many times before, this is nothing new – to quote my 5 year old son Blah, Blah, Blah.

In short, US markets are nothing but a pendulum swinging from high to low and back again. Over time it works its way higher.

You see, it HAS to work its way higher. I will pause while you digest what an emphatic comment that was. Less I overpromise, the past is never a guarantee for the future of investments BUT markets are a sum of companies all incentivized to make money. As long as people have needs, then companies have value. Companies make money and given enough time making a little bit each year they will appreciate. Some will fail, a new company will meet the need and the markets will reflect. As long as we all accept and use the monetary system, this pattern should continue in the long run. Now, if we are debating the sustainability of our monetary system or feel a revolution is around the corner…well, I suggest you catch up on your dooms day prepping.

Understanding markets must move higher in the long run (5,10,15 years), lets turn our attention to the current fears and gain some understanding about WHY the Wilshire 5000, NYSE, DOW & S&P are all down over -10% for the year and why the broad markets such as the New York Stock Exchange and Wilshire 5000 are down over -18% and -15% for the past 1 year (data from Morningstar, 2-11-2016).

The Domino (or Pendulum) Effect

Domino 1: OIL

The first domino to fall was oil prices, declining over 80% since the 2012 high of $126.55 for Brent Crude (source, Bloomberg Brent Crude Pricing). Large price fluctuations in commodities are normal and a main reason we don’t invest directly into commodities, but this fluctuation is well beyond normalcy and has been a result of a change in OPEC price management, oversupply, and short term traders. While the price of Oil should never have been over $100 (contrary to Goldman Sachs prediction of $200 for 2008 or $90 for 2015), Oil also should not be $30. Both $100 and $30 are extreme pricing measures reached only by irrational exuberance and irrational fear. Going above and below these marks is largely the result of day traders pushing prices based on nothing but speculation. Long term real value based on fundamentals (supply and demand) is somewhere between $45 and $60. Unfortunately traders, emotion and lack of rational thought can and will dominate at times. In short, Oil price has been crushed and this is the was the first domino to fall.

Domino 2: Credit Markets

Credit markets are always the second domino. In 2008 it was sub prime loans and then credit markets. In 2015/2016 it’s been oil and then credit markets. Simply put, when companies cant access money as cheaply as before then credit is more expensive. When credit gets expensive it leads to slow downs in general economies and often can lead into recessions. It is one of the best indicators of coming recessions. Credit spreads are a great indicator of cost of credit and show the coupons for lower grade companies (high yield bonds) against low risk treasury such as 2 year. Since Oil prices declined so fast and furious, many oil & commodity companies will go bankrupt. They will not be able to pay on the bonds and thus the banks lending will now charge more for access to money. Of course the amount of bad bonds is fairly small, but the concern that it could spread drives yields up as well.

Take a look at the graph below to see the relation to recessions when this spread exceeds 7.33%.

For most, getting 6-8% on bonds is a good trade off. Even if 10% of companies go bankrupt, you still end up with a huge long term payout that well exceeds a 5% income goal. Long Term Opportunity? Most likely. We are moving more bonds into higher yields as this story unfolds. Our lower risk bonds served us well year to date for moderate clients, but we are in the business of meeting long term goals and this seems like a common sense move to meet clients actual needs.

Domino 3: Equity Markets (Stocks)

Will the increased cost of credit lead to issues with companies beyond energy and commodities? For example, much of the emerging markets rely on oil & commodities for supporting economic growth. Without emerging markets buying goods from China will China decline? If China declines enough, will Apple be able to sell enough iPhones to meet earnings expectations? If Apple does not meet earnings expectations then the price of the stock should fall temporarily.

This is where we currently are in the cycle of dominoes. Stocks have had fairly good earnings but are declining due to a foggy outlook from global concerns. While the data has not actually hit markets yet, the fear that it may has caused price declines. The more fear that comes, the more prices will decline. If the credit markets get bad enough and global issues continue, we would expect recessionary conditions to take place in the near future. If the fear does not manifest then we would expect a significant bounce in stock prices over the next 12 months. We believe the likelihood of a reversal in fear still outweighs a recession, BUT even if we entered a recession the market has already declined 15%-20% from 2015 highs depending on the index you evaluate. The normal recessionary decline is around 32% (Source, JP Morgan). That means we are roughly half of the way down to typical recession lows for the market. Why would anyone change course after they have experienced most of the pain – like quitting at mile 15 of a marathon. The longer this continues the more people will quit before the turn around. We hope people quit – it is what gives us an advantage. The more who quit simply equates to more money/value in our investments when prices recover.

Domino 4: Recession (general economy & main street)

The final domino to fall would be a recession in the US. Currently we have an economy with a 2015 real GDP growth of 2.60% (2015 world GDP rankings , BEA). 2.60% economic growth is a far cry from contraction. Some areas like home building have even grown at 9% over the past 12 months according to the bureau of economic analysis. Of course areas such as Energy and Industrials have been dragged down due to the commodity pricing, but so far other areas have outweighed and allowed our economy to continue growing. If the global fears sparked by low oil persist long enough, perhaps we could flirt with recession. However, the probability still remains low.

Evergreen Wealth Management’s Response

Markets are like a giant pendulum and swing from irrational exuberance to irrational fears. We are seeing irrational fears start to happen. They may continue for a bit longer, but at some point the pendulum will head back the other direction. As long term investors, now is the time to take advantage of such fears. We don’t expect the markets to go much lower from here but anything is possible short term when fear takes over.

Since each portfolio we manage is specific to the client’s own needs, let me address in general the 2 approaches and what we are doing:

Growth Investors: Growth investors are well positioned for any rebound and generally see full market downside with expectation of capturing full market upside and hopefully more when things turn around. We are well positioned for the turn around. Keep contributing to your accounts, your 401(k) / 403(b), etc and allow the power of adding money through the volatility work for you. Being able to add during down times is a great gift for growth investors accruing and building for retirement. If you are able to add more, now is a great time.

Income Investors: Income investors continue to see 4-5% income generated. We are working on rotating from a few lower income areas into higher income to get a small raise during the declines. We continue to allow cash to build as appropriate for your risk level and timeline for accessing the money. The biggest risk you face is not ups and downs but having cash available at the time you need it. We have a plan to build your cash so when you retire it is available. If retired, we are building for your ongoing distributions. In both cases, we aim to reduce or eliminate any need to sell during declines which would permanently impair your income flow. For income investors not needing the money but whom simply like the risk reducing properties of a building cash pile, we are actively reviewing and putting money to work in accordance with your goals.

Conclusion – How this may play out

Having been through this a number of times, I have a good idea of what might happen. No idea on the exact timing, but the pattern should go something like this:

1. Oil prices get a boost in a shocking fashion from either a surprise announcement from OPEC or surprise report about supply shrinking faster than expected. First the day traders shorting the market will cover all bets and send price upward 20-40%. Then we will have institutions start to dip into more long term buying and add on another 10%+. Oil prices stabilize and settle at least 40-60% higher than today at around $40-$50.

2. In process of oil stabilization, the credit markets are able to quantify the risk around the bond portfolios with more precision and stabilize with a significant rally, bringing spread back in line.

3. Equity markets work in lock step and rebound strong on the backs of easing credit concerns, with companies returning to a more normal price that reflects real value.

4. Time marches on and investors forget about the storm of 2015/2016, markets move back to a new high and headlines switch to optimism.

When this will happen? No one knows - but we are 1 week closer than last week. How exactly this plays out, no one knows. But the pattern and pendulum will repeat and swing again to optimism and exuberance bringing prices forward to new levels. The real question has always been; who really wants to make free money without any work? Who is capable of really ignoring the white noise and short term swings? Who can truly rise above emotion? The intelligent investors will shout YES and will again be rewarded. Those who change courses may find themselves hurting with regret. Be intelligent!

“The most important quality for an investor is temperament, not intellect. You need a temperament that neither derives great pleasure from being with the crowd or against the crowd.” – Warren Buffett

Contact the author, Stephen L. Hanley: [email protected]

Learn about Evergreen Wealth Management at www.investevergreen.com

Give us a call: 877-655-2118

Important Disclosures

Results mentioned for shown allocations were derived using our model allocations which clients are subscribed. Allocation results are given only for general range guidelines and discussion. To view your account performance login to your custodian and view performance or review your statements.

Evergreen Wealth Management, LLC is a registered investment adviser. Information presented is for educational purposes only and does not intend to make an offer or solicitation for the sale or purchase of any specific securities, investments, or investment strategies. Investments involve risk and unless otherwise stated, are not guaranteed. Be sure to first consult with a qualified financial adviser and/or tax professional before implementing any strategy discussed herein. Past performance is not indicative of future performance.

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investevergreen-blog · 10 years ago

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October 2015 Commentary

History Repeats - 11/03/2015

by Chief Investment Strategist, Stephen L. Hanley

In our latest market update, we detailed a historical look at market pullbacks. We illuminated the clear fact that 10% or greater pullbacks occur on average every year. 20% pullbacks on average every business cycle and the dreaded 30% pullbacks are a rather rare occurrence. In the midst of a violent August & September swoon in the markets, we remained disciplined and ignored the negative trends and even swapped some bonds for equities to take advantage of opportunity. Thankfully, client portfolios have been rewarded as we stayed the course and practiced discipline. Aggressive portfolios have turned positive for the year, while income takers are between +1% and -4% for the year depending on income levels. Mr. Market proves once again, volatility is a normal and very healthy part of investing. Our focus on meeting your needs such as income today or long term returns 5-10 years from now allows us to completely ignore the month to month white noise and make sound long term decisions for your desired outcomes.

Mr. Market

With summer past and earnings season underway, we are seeing many positives starting to unfold.

• As of this article around 2/3rds of the S&P 500 companies that have reported Q3 earnings beat expectations. We have also seen revised upward guidance indicating improving conditions. • Many of the earnings were suppressed from the continued strength in the dollar. When the dollar, rates and oil all start to normalize this may provide a large tailwind for earning upside. • Large outflows from the past 4 months sit in cash, waiting to return to markets (likely after FED raises rates and provides a bit more clarity). • Companies are running very lean so we would expect margins and profits to hold up well through the end of the year and into 2016. • Valuations are certainly not the bargain they were in August, but across the board look fair. P/E Ratio for the S&P 500 remains in a healthy range. If dollar declines we would see the PE ratio look very attractive and likely induce another leg up in the market. • The selloff in higher yielding bonds created some opportunity for bond allocations utilized by income takers. We were able to increase exposure from some core bonds into higher yielders during the selloff. • China, Oil, FED have all contributed to the years volatility and we will save each of these topics for a more in depth article later this year. Suffice to say, Mr. Market and myself are starting to agree…. Fears may in fact be overblown and positives are starting to outweigh the negatives.

Opportunity Evaluation

As always, we are constantly looking for opportunity that aligns with your risk, return and income needs. We continue to see some deals in the larger companies hurt by the strong dollar, international selloff and oil price declines. We have positioned for the long term in accordance with this thesis and value. In the short run this may provide a 2-3% drag relative to some benchmarks (I don’t expect Merck, Coke to pace Amazon in all environments) , but it allows us to capture higher income and cash flows with proper risk which we believe will turn into solid total return that meets your desired outcomes.

Summary

Income and Cash Flows remain solid which means all desired outcomes continue to be met! When the year started we warned about a swoon likely to take place of 15% or more. We cautioned to ignore because it is healthy and normal and would likely be short lived. Our hope was that 2015 would largely be a flat to slightly negative year to allow earnings and cash flows to catch up to market valuations. We much prefer healthy pullbacks to bubbles that burst 30%.

Let me close with the quote that will determine your success as an investor, which we embrace daily:

"The most important quality for an investor is temperament, not intellect. You need a temperament that neither derives great pleasure from being with the crowd or against the crowd." – Warren Buffett

Important Disclosures

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investevergreen-blog · 10 years ago

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ALL THINGS FED & DOLLAR

by Chief Investment Strategist, Stephen L. Hanley This year we have seen continued divergence between North America and the world against a backdrop of volatile oil prices and central bank pressures.

Persistent themes included: • Strength in the U.S. dollar • Stimulus efforts by the European Central Bank • Speculation about when the Federal Reserve will begin to raise interest rates • Declining Oil & Commodity Prices • Moderating GDP (Gross Domestic Product)

All Things Fed & Dollar The US Federal Reserve actions and prediction of those actions seem to be the dominant economic force for the market in 2015, controlling the themes above. Janet Yellen (FED Chair) and her team find themselves in a tough position. While prudence exist in having slightly higher interest rates, anticipation of tightening by the FED to move rates higher generally creates a stronger dollar and thus reduces inflation. While this is certainly one known effect of raising rates, the FED does not want to induce a deflationary economy that creates years of stagnation. With inflation very low already (largely due to oil price decline), any move potentially could stall economic activity and cause greater harm than good in the short run. Janet Yellen recently commented to this exact point stating that she’s worried about the potential risk of “secular stagnation” from demographics and lower productivity gains. This thought process would warrant the FED and monetary policy keep real rate of interest low in the absence of expansive fiscal policy (think congressional policy). In our opinion, Congress has continued to avoid making tough decisions on fiscal policy that place the FED in this no win position. Until congress can get the budget and spending aligned more properly, the FED will remain in a tough position attempting to spur the economy and control inflation/deflation without any help from congress. The solution for proper expansion of fiscal policy to unleash economic growth and avoid stagnation has historically been deregulation, tax cuts and globalization. This is not a political stance so much as a case study gathered from history of stagnation. Most recently you can study the economy of Japan to understand better the actions that lead to stagflation. Without diving into the complexities, Japan has identified the main inputs to stagflation as; excess savings, special interest groups creating market imbalance, policy misalignment, structural impediments, currency appreciation, global capital flows. (referenced, Daniel I. Okimoto, Principal Investigator Senior Fellow, Emeritus)

We believe the real effects of raising rates to be minimal. Rather than summarize ourselves, we will point to some of the most accurate commentary from economist Brian Westburry’s First Trust Monday Morning Outlook (9-21-2015) to support WHY:

If the Fed had hiked rates last week, reserves would have stayed exactly the same. All the Fed would have done is announce that it was paying more to banks on excess reserves, as an enticement not to lend them. Every dollar of excess reserves would have remained in the system. A rate hike would not rip away the punch bowl, in fact the punch bowl would still be overflowing with excess reserves waiting for someone to slurp them up. In the past, when the Fed has raised rates, banks did not hold any significant amount of excess reserves. So higher short-term rates meant it was tougher for banks to acquire the funds they wanted to lend. Now, many banks are filled to the brim with excess reserves and are barely trading federal funds among each other. Sometimes they say, “follow the money,” but we suggest “follow the profits” to understand Fed actions that confuse you. So let’s do it. Right now the Fed owns $4.2 trillion in bonds which pay whatever they pay, while it gives banks ¼% on reserves. The “spread” generated a profit last year of roughly $100 billion, which the Fed then turned over to the Treasury. If the Fed would have increased what it paid banks on reserves to ½%, this would have reduced the Treasury cash inflow by about $7 billion over the next year and this money would have gone to banks. In other words, the Fed and Treasury have an incentive to keep rates very low so that their profits stay high. The biggest problem the US has now with its economic management team (including the Fed) is that it has spread the narrative that only QE and other government programs saved the economy during the crisis. We do not believe this one iota. In fact, we believe government rules forced Fannie Mae and Freddie Mac to buy sub-prime mortgage bonds. That created the crisis. Yet, it serves government interests to blame it on banks and the private sector. This has helped create a cottage industry of Black-Swan birdwatchers. Instead of looking for an answer, they just claim 2008 was like a severe earthquake that was unpredictable. The pessimists create fear as they find a new Black Swan every week, which, for investors who believe this stuff, is terrifying. But they have also enhanced the narrative to include the idea that if the Fed raises rates, the only support for growth will be ripped away. This is also a misconception. Does anyone with common sense really believe that QE and zero percent rates invented the Apple Watch, or increased the efficiency of fracking, or created Uber, vertical farming, 3-D printing, the cure for Hep-C, or any of the other massively wonderful new technologies and inventions we have seen put in place in the past six years? The Fed does not cause real, long-term wealth creation. It never has and it never will. It either accommodates growth by printing the right amount of money, therefore avoiding deflation, or it prints too much money, which won’t stop growth but will cause inflation. It can cause harm by allowing the money supply to collapse, but once mark-tomarket accounting was fixed in March 2009, that possibility evaporated. There is an argument running around that says: If the Fed wouldn’t, or couldn’t, raise interest rates, then there must really be something wrong with the economy. This argument is sophomoric. It gives the Fed some kind of supreme, omnipotent power of knowledge that no one else has. But, other than private bank information and probably some foreign government secrets, the Fed has access to the same data that we do and none of it suggests the US economy needs zero percent interest rates. Initial claims have been below 300,000 for 29 straight weeks. And anyone who claims 173,000 new jobs is a clear sign of economic problems, especially in August (which is so often revised higher), is spinning the data. Yes, China’s growth has slowed to 7%, from 10.6%. So what? Japan collapsed in 1990 when it was the #2 economy in the world, and the next ten years were fabulous for US investors. All in all, what is really going on is that many people think there are Black Swans flying around everywhere, and that the only way to protect the US economy from them is with an Uber-Dove. It looks like Janet Yellen has decided she is that Uber-Dove, despite a real lack of evidence that Black Swans exist or Fed policy has protected the economy from them in the past six years.

Conclusion These concepts of stagflation are all coming together in the US currently with excess corporate savings, special interest leading to over regulation, FED and congress policy misalignment, government ties to corporate, strong dollar hurting growth, policy impeding maximum trade flows. All areas that create stagflation are now being fully realized within America. All is never lost when you are the largest economy in the world and many solutions and motivations for reversing this trend still exist. If the government can create a more favorable environment for companies to release money and step on the accelerator then we can quickly reverse some of the recent movement toward stagflation. Until then we will likely see economic activity well below maximum potential (this is not to say we will not see growth, just less than what is possible). Perhaps a normal recessionary period would be welcomed to bring on some changes and flush out these impediments. We would much rather have, and greatly welcome a normal economic recession than years of economic stagflation.

For most, the concept of secular stagnation lies well outside mainstream economic thinking. However, over the years to come, it may very well define the future economy of America and opportunity for investors, only time will tell.

Evergreen Wealth Management, LLC is well educated on this possibility and has a strategy to deal with the burden and opportunities it may create.

Disclosures Evergreen Wealth Management, LLC is a registered investment adviser. Information presented is for educational purposes only and does not intend to make an offer or solicitation for the sale or purchase of any specific securities, investments, or investment strategies. Investments involve risk and unless otherwise stated, are not guaranteed. Be sure to first consult with a qualified financial adviser and/or tax professional before implementing any strategy discussed herein. Past performance is not indicative of future performance. Index results do not reflect management fees and expenses and you cannot typically invest in an index.

#investmentupdate

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