November 2017
Market Update
(all values as of 08.31.2020)

Stock Indices:

Dow Jones 28,430
S&P 500 3,500
Nasdaq 11,775

Bond Sector Yields:

2 Yr Treasury 0.14%
10 Yr Treasury 0.72%
10 Yr Municipal 0.81%
High Yield 5.38%

YTD Market Returns:

Dow Jones -0.38%
S&P 500 8.34%
Nasdaq 31.24%
MSCI-EAFE -6.23%
MSCI-Europe -7.39%
MSCI-Pacific -4.42%
MSCI-Emg Mkt -1.18%
 
US Agg Bond 6.85%
US Corp Bond 6.94%
US Gov’t Bond 8.09%

Commodity Prices:

Gold 1,973
Silver 28.43
Oil (WTI) 42.82

Currencies:

Dollar / Euro 1.19
Dollar / Pound 1.33
Yen / Dollar 105.37
Dollar / Canadian 0.76
 

Macro Overview

An improving economic environment and earnings optimism propelled markets higher, along with prospects that there might be some agreement on tax reform in Washington.

The House of Representatives released a draft of tax policy proposals known as The Tax Cuts & Jobs Act. The prospect of lower taxes for corporations and individuals are part of the proposals, while also targeting tax avoidance by multinational U.S. firms, reassuring markets that fiscal reform could prove possible.

Hurricane influenced rebuilding efforts underway in Texas and Florida are expected to become more visible via labor and materials data over the next few weeks. Economists expect an increase in job placements and material costs as insurance claims start to pay out. Hurricane Harvey destroyed over 15,500 homes in Texas, while Hurricane Irma damaged 90% of the homes in the Florida Keys.

Apart from hopeful tax reform passage, equity markets have soared due to stronger global demand, improving earnings, and fewer regulatory hurdles. Internationally, global growth surpassed 4.5% in the second quarter, following a 3.9% increase in the first quarter. The data suggests that global production and consumption is increasing, eventually translating into higher earnings for global equities. The International Monetary Fund (IMF) issued increased growth estimates for 2017 & 2018 following better than expected growth data.

The U.S. economy posted two consecutive quarters of GDP growth above 3% in the second and third quarters, marking the best six-month consistent period of growth in three years. Gross Domestic Product (GDP) grew at a 3.1% rate in the second quarter and 3% in the third quarter, per Commerce Department data. The subdued third quarter results are believed to be attributable to Hurricanes Harvey and Irma as economic activity came to a halt for portions of Texas and Florida. Economists believe that rebuilding efforts following the storms will give GDP growth a boost in the fourth quarter. Historically, U.S. GDP has averaged around 3% annual growth.

Proposed business tax reforms are expected to increase business investment, which has lagged in recent years. The Federal Reserve Bank of St. Louis released data showing that business investment rose in the second and third quarters. Overall, a rising trend in business investment is a confirmation of improved confidence held by companies on economic and tax reform prospects. (Sources: House.gov, Commerce Department, Federal Reserve)

 

 

 

 
Equity Markets and the "Melt-Up"

Sinister Month Of October Rebuffed – Equity Markets

This October marked 30 years since the market drop of 1987, when the Dow Jones Industrial Average fell to 1,738, losing 508 points. The 22.6 percent collapse in 1987 is equivalent to a drop of about 5,200 points in the index today. The benchmark U.S. S&P 500 index plunged 20.5 percent on that same day in October 1987, equal to a drop of over 520 points today, and the Nasdaq dropped 11.4 percent, comparable to a drop of about 750 points. Another historical note is that October has been recognized as the most volatile month of the year. This past October was an exception, with the least amount of volatility of any October going back to 1928.

Earnings, the single most important factor for stock prices, have been rising in sync with stock prices, meaning that improved earnings are validating the bull argument.

International markets are following the rise of U.S. equity markets, reflecting optimism about world economic growth. Steady buying in U.S. markets has transitioned over to European, Asian, and emerging markets over the past few trading sessions. Broad-based economic growth internationally is fueling stock market appreciation as well as inflationary pressures. A weak dollar has also continued to buoy large U.S. multinationals allowing their products to be priced more competitively worldwide. (Sources: Dow Jones, S&P, Nasdaq, Bloomberg)

The “Melt-Up” Hypothesis

There has been a lot of discussion about the markets beginning a “melt-up” phase where euphoria takes over and common sense takes a back seat to greed.  Historically, some of the largest gains have been made during the final innings of a bull market as investors who have sat on the sidelines rush to play catch up and jump in with both feet (and all their money).  The problem for most of these investors is knowing when to get out and they are typically the ones left holding the bag when the inevitable (and usually violent) downturn finally comes.   Online brokerage firms like Charles Schwab are reporting record numbers of new account openings as the late-comers rush to cash in on the rally.   At the same time, there has been a dramatic decline in institutional stock purchases meaning the smart money is running for the exits while the retail investor is going all-in.  Due to the nature of this bull market we have been skeptical of the melt up hypothesis.  Unlike previous bull markets that were fueled by strong economic growth and increases in consumer wealth (low unemployment, rising wages) this bull market has been almost entirely fueled by central bank interference (never ending quantitative easing).  In this bull market, growth has been marginal and consumers have less disposable income as household debt levels are once again hitting record high levels.  For most of this rally investors have been told that while this was the weakest recovery in history not to worry, interest rates were low and central banks were accommodative (purchasing trillions in assets per year and near zero interest rates).   Now, rates are rising and central banks are slowing their asset purchases we are told that it is all about earnings and the “synchronized global growth” story.   The flaw here is that since 2014 the economy has grown by a little less than 9%, top-line revenues by just 3%, and reported earnings by just 2%.  However, during this same period the S&P is up over 30% which tells us investors should be cautious.  Add in the record breaking increase in global debt, which is now over 220 trillion (much of which is junk corporate and sovereign debt as well as  shaky consumer loans) and the writing should be on the wall for anyone willing to read it.  While we are not 100% convinced in a melt-up of 20, 30, or even 50% as many analyst suggest, we believe a melt-up is possible and has likely begun.  However, we believe that investors wishing to gamble on the melt-up take some common sense measures to protect against a complete disaster.  Given the historically low VIX purchasing insurance via options are an extremely cheap way for those wishing to try and ride the melt-up to protect themselves if instead they see a melt-down.

 

 
Fixed Income Review

 

FIXED INCOME REVIEW 

Shift In Bond Yields 

The yield curve for U.S. government bonds is flattening while shorter-term rates have risen as Fed hike expectations have increased. The 2-year Treasury reached 1.60% in October, its highest level since 2008. Rising shorter-term maturity bonds with little or no change in longer-term maturities is viewed by economists as a pick up in shorter-term inflation as well as the expectation of a coming rate increase by the Federal Reserve.

The 10-year U.S. Treasury is becoming more of an attractive option for international investors as the yield on the benchmark bond has risen versus its developed market peers. The yield on the 10-year Treasury at the end of October was 2.38%, compared to a 0.04% yield on the Japanese 10-year government bond, 0.36% on Germany’s and 1.26% on the British 10-year government bond. (Sources: Bloomberg, Fed.)

 

Credit Market

We have written extensively on our website and in past newsletters about the historically tight spreads in the credit markets.  The “spread” is the excess compensation an investor receives when purchasing a bond which is not guaranteed by the U.S. Government (considered the risk-free rate).  The spread is generally expressed in basis points over the corresponding treasury.  In last months newsletter we explained in detail how investors are currently receiving historically low spreads and accepting extremely poor covenant protections (bad terms).  This means investors are not being properly compensated for the additional risk they are taking for investing in non-government guaranteed bonds.  While spreads continued to remain tight in October, the first week of November has seen some extreme widening as investment grade corporate bonds have widened 5 basis points.  While this may not sound like much, 5 basis points on a 10 year corporate bond equates to nearly 3/8ths of a point (meaning a loss of nearly $3750 per $1 million invested).  BofA Merrill Lynch Global Research has attributed much of the rise to record supply volumes in October of $131b which have left dealer inventories at their highest levels since July of 2014 and believe the widening is temporary.  In the short run BofA may be correct and this widening is temporary but longer term we believe spreads will widen significantly from their current historically low levels meaning bondholders could see steep price declines.  As we noted above, a mere 5 basis point move equates to a loss of over $3000 per $1 million invested meaning a 50 basis point increase would produce a price decline of over $30,000 per $1 million.  To put this in perspective, IG corporate bond spreads were 50 basis points wider as recently as recently as June 2016 and were over 80 basis points higher in February of 2016 (which would equate to a loss of over $50,000 per $1mm invested or 5%).

Ok, many readers are likely thinking aloud that a 5% loss doesn’t sound so bad.  However, it is important to note that 50-80 basis points of widening would merely bring things closer to the historical norm.  Given how tightly wound the credit markets have become (record debt levels + tight spreads) any credit event could send spreads soaring 100 basis points or more.

Now lets look at the where the real trouble could lie in the corporate bond market – High Yield Bonds!

(Continued on next page)

 

 
Fixed Income High Yield Market

High Yield Bond Market

The chart below shows the option-adjusted spread for U.S. high yield corporate bonds.

In our October newsletter we reported that high yield spreads had been bumping up against historic lows and it was our belief that spreads would begin to widen (we obviously did not know it would begin almost the exact day we published our newsletter but blind squirrels find nuts too!!).  As you can see from the chart, since late October spreads on high yield corporate bonds have widened 29 basis points from 3.38% October 24th to 3.67% on November 8th.  Now to put this in perspective, 30 basis points of widening equates to approximately 1.875 points or about $18,000 per $1 million invested. And remember that is just in 2 weeks!  As the chart above shows the spread on high yield corporate bonds was 5.11% (511 basis points) a year ago.  So doing the math if we return to the levels of just one year ago (that were far closer to historical norms) it would mean that high yield bonds could widen another 1.44% (144 basis points) equating to a loss on a 10 year corporate bond of approximately of approximately 8 points or another $80,000 per $1mm invested bringing the total loss to nearly 10%.  Due to the factors we will discuss later in the newsletter, we believe things could ultimately get much worse and would not be surprised to see 300 or more basis points of widening on any credit event or even a mere 10% market correction (a bear stock market could easily drive spreads out 500 basis points or more).

High Yield Market Winners and Losers

Losers:

We have written extensively in past newsletters about the Tesla corporate bond offering which took place in August.  We warned investors that this could easily have marked the end of the high yield euphoria and so far it appears we were dead right.  The TSLA 5.3% of 8/15/2025 have fallen several more points since our last newsletter and are now trading at $94.  That represents a 6% loss since they were issued in August.  We wrote on our website that one year ago these bonds would have been priced at closer to 10%.  However,  institutional investors gave Tesla a blank check with a 5.3% interest rate and extremely poor covenants as the deal was heavily oversubscribed with investors fighting over their share of bonds (the deal was upsized $300mm to accommodate the yield hogs).  As the saying goes, pigs get fat and hogs get slaughtered and investors holding the $1.8 billion in Tesla debt are being carved up as we write.

 

 

 

 

 

 
Fixed Income - High Yield Market

High Yield Winners and Losers

Winners:

As far as winners the non-investment grade asset-backed securities (ABS) market has become the new feeding frenzy. In our last newsletter we recommended investors shift from high yield corporate bonds into high yield ABS and that trade has been a Houston Astros style grand slam.  While high yield corporate bonds have widened nearly 30 basis points, the high yield ABS have actually tightened by at least 30 basis points. Spreads on BB rated auto ABS have moved from over 330 basis points to around 295 basis points. One large hedge fund client actually called a couple weeks ago to let us know he was going to be selling his rather large BB auto ABS and would be putting out a bid wanted list. A few hours later, he called and said upon reflection he would wait until the new year to see if spreads would get below 300 bps. Well, it didn’t take two months it took two weeks!! He has now begun to sell some of his holdings and shift into higher quality ABS which should hold up far better should we see a crack in the credit markets. While we still prefer high yield ABS over  high yield corporates, we would caution against starting new positions at these levels with the exception being very short duration, high quality bonds which will weather a credit event relatively unscathed.

The Credit Bubble

We have written extensively on our website and past newsletters about the bloated, overvalued state of the credit markets.  This week David Stockman wrote an article on his Contra Corner website calling the credit markets the “black swan in plain sight”.  In the 8 weeks since the public debt ceiling was suspended the national debt has spiked by $640 billion or about $16 billion per day!  The U.S. national debt is nearly $20.28 trillion and increasing at just under $1 trillion per year.  Household debt is now approaching $15.1 trillion and total worldwide debt will likely break $230 trillion this year.  If you couple record debt levels with record tight credit spreads, add a slow down in central bank “investing”, throw in an over valued stock market with a touch of rising interest rates and you have Granny’s recipe for a financial Christmas Turkey dinner.

In our opinion it isn’t a matter of if but when as we are simply reaching levels that are unsustainable.   There is a record amount of high yield debt coming due between 2018-2020 which will need to be refinanced.  If the markets become less accommodative this would lead to an enormous amount of defaults and send shocks throughout the credit markets (think 2008). Cramer can scream about the “synchronized global recovery” until he explodes and it sounds great but unless everything we learned in Econ 101 was a lie, this Turkey is overcooked.

 
Consumers Spending More and Saving Less

Consumers Are Spending More & Saving Less – Consumer Behavior

Recent government data reveals that Americans have been supporting their spending with their savings. The increase in spending is also recognized by economists as a sign of optimism and consumer confidence. Commerce Department data show that consumers have been spending more, as measured by the Personal Consumption Expenditures (PCE), and saving less, as measured by the savings rate, which fell to a ten-year low of 3.1% in September.

Integral components of consumer expenditures include income, credit and savings, basically where we get the money we spend. Every month, the Bureau of Labor Statistics tracks various data such as how much we spend, reported as Personal Consumption Expenditures (PCE), and how much we save, represented by the savings rate.

For many Americans that save diligently, using credit to spend is usually a last resort. So, for those consumers, spending from savings occurs before tapping a credit card. The most recent data show that consumers, as measured by the PCE, have been spending more over the past year. The concern is that consumers are concurrently saving less, meaning that savings are starting to go towards expenditures. Economists view this dynamic as a possible rise in prices and inflationary pressures where current income may not be keeping up with rising inflation.

Continued job and wealth gains have inspired consumers to spend more confidently. Another notable data set, tracked by the Federal Reserve, is household net worth, which revealed an increase in its most recent release, adding to consumer confidence.
Source: BLS, Federal Reserve Bank of St. Louis

Ok folks, we can throw this into our previous discussion on credit markets and debt.  Let’s not forget that margin debt has just hit levels we haven’t seen since before the credit crisis.  And if there isn’t enough in the brokerage account to pay for the $1100/month Mercedes payment just charge it to your unsecured credit card which by the way has also reached near record levels.  But again, what can go wrong? Certainly the folks at CNBC think nothing is wrong with this picture its BUY, BUY, BUY!  Well, at least until it isn’t.

 
Car Prices are Plummeting

Car Prices Are Falling – Auto Industry

Seven consecutive years of increasing U.S. auto sales have put a glut of vehicles on U.S. highways. In addition, a significant number of those sales were with a lease, leading to a rising tide of cars flowing back into the market as lease terms expired.

As automakers have added manufacturing capacity, they have also been aggressive in offering larger incentives on new vehicles in order to maintain record sales momentum. That has put downward pressure on the entire market.

Consequently, the number of drivers that owe more on their cars than they’re worth is surging. Americans are paying on 108 million auto loans currently, according to the most recent Federal Reserve data. That represents roughly half of all licensed drivers in the U.S. Among those that carry loan balances, the Federal Reserve says auto loans make up between 10 percent and 23 percent of their total financial obligations.

 

The average used car lost 17 percent of its value in the past 12 months, dropping from $18,400 to $15,300, according to data from Black Book, an auto analytics company. That annual depreciation figure has also been increasing steadily, with the average used car today depreciating nearly twice as fast as it did in 2014, when the annual rate was just 9.5 percent.

Sources: Black Book, Federal Reserve

Another interesting article and a subject we have written extensively about on our website.  While this may seem counter to our love of ABS (even autos) many of the ABS deals have been structured to withstand poor residuals and even hi defaults and repossession rates.  The key is knowing how to analyze the deals properly and find the crème of the crop when it comes to underwriting standards and credit enhancement.

 
Social Security Update

Social Security Payments Increasing By 2% – Retirement Planning

Social Security recipients are due to receive the largest increase in benefits in six years. But for many recipients, the increase in payments will go towards higher Medicare costs.

The Social Security Administration announced a 2% increase in benefit payments effective in late December 2017 for disability beneficiaries and in January 2018 for retired beneficiaries. The 2% increase is the largest increase since a 3.6% increase in 2012.

Many are concerned that the 2% increase may not cover expenses that are rising at a faster rate, including other essential items such as food and housing. The latest increase also affects the premiums for Medicare Part B, which covers doctor visits and outpatient care. Medicare premiums are expected to increase at the beginning of the year, minimizing net increases in Social Security payments.

The establishment of Social Security occurred on August 14, 1935, when President Roosevelt signed the Social Security Act into law. Since then, Social Security has provided millions of Americans with benefit payments. The payments are subject to automatic increases based on inflation, also known as cost-of-living adjustments or COLAs which have been in effect since 1975. Over the years, recipients have received varying increases depending on the inflation rate. With low current inflation levels, increases in benefit payments have been subdued relative to years with higher inflation. The COLA adjustment for 2018 is 2.0%, a steep increase from the 2017 adjustment of only 0.3%.

As of October 2017, over 66.7 million Americans currently receive Social Security benefit payments, with 46.3 million aged 65 or older. The Social Security Administration estimates that Americans will receive over $931 billion in Social Security benefit payments in 2017.

Over the decades, Americans have become increasingly dependent on Social Security payments, however, for some Americans it may not be enough to rely on Social Security alone. Unfortunately, Social Security is a major source of income for many of the elderly, where nine out of ten retirees 65 years of age and older receive benefit payments representing an average of 41% of their income. Over the years, Social Security benefits have come under more pressure due to the fact that retirees are living longer. In 1940, the life expectancy of a 65-year old was 14 years, today it’s about 20 years.

By 2036, there will be almost twice as many older Americans eligible for benefits as today, from 41.9 million to 78.1 million. There are currently 2.9 workers for each Social Security beneficiary, by 2036 there will be 2.1 workers for every beneficiary.

Source: Social Security Administration