Tuesday, March 6, 2018

Get on the Rollercoaster Now, This Stock Market is Going Higher!

I spent the last several weeks analyzing the cause and effect of economic events that occurred during the month of February and it is hard to pinpoint exactly what traders perceived as being negative. The economy continued to be very strong, earnings continued to go up, and interest rates, while higher, are still by any reasonable standard remarkably low.

Throughout this blog, I will try to give you the reasons why the market sold-off in February and why those reasons are misplaced. In addition, I will address the issue of tariffs so that you have a better understanding of what it means and why it is not the scary reality that traders would like you to think.

As depressing as February was, it certainly was not unexpected. The stock market has been going up continuously since November 2016, so a pullback was to be expected. Despite appearing scary at times, the pullback in February was relatively minor. Higher volatility always leads to unnerving to the less than committed investors. One thing that I will always emphasize to investors is that stocks pull back for a reason. Therefore, you must analyze the reason and interpret whether it is real or imaginary. As for the month of February, it was completely imaginary.

In February, the Standard & Poor’s 500 index was down 3.7%. However, do not lose sight of the following important information. For the 2018 year, the S&P 500 is still up 1.8% and up 17.1% for the one-year period. The NASDAQ composite was down only 1.8% for the month of February and up 5.5% for the 2018 year. The one-year return for this index is 26.1%. The Dow Jones Industrial Composite was down 4% for February but was still up 1.7% for 2018. It was also up a satisfying 23.1% for the one-year period ended February 28, 2018.

Also, if you believed for a second that your asset allocation should have been more heavily weighted in bonds to take the volatility out of your portfolio, you would be wrong. Bonds did not offer any protection against volatility in February and, frankly, have underperformed for basically years. I am always baffled when I see a young person allocate a portion of their portfolio to bonds with no discernable good reason. Maybe they read a magazine article that threw out the generalization that everyone should own bonds. In many cases, that advice is just wrong – very wrong for this year so far!

As demonstrated in February, the Barclay’s Aggregate Bond Index was down 0.09% for the month and is down 2.1% for the year. More importantly, for the one-year period, the bond index is only up 0.03%. For the year of 2018, the S&P 500 index is up 1.8% and the Aggregate Bond index is down 2.1%. If you really thought that you were being protected by your asset allocation using a substantial sum of bond investments, you can see above that there is almost a 4% differential between those two indexes and that is only after 2 months in 2018.

One could blame the market volatility on the testimony of the newly appointed Federal Reserve Chairman, Jerome Powell. While watching these hearings, it is quite clear that these congressmen know nothing about economics. The Federal Reserve Chairman tries his best to avoid giving a direct answer to a question where no direct answer probably exists. Economics is a lifetime study. That being said, speaking about complex economic concepts to congressmen with no training in the field always leads to comical conversations. What is not comical, and downright sad, is that the congressmen’s lack of understanding makes a mockery of these hearings. I will give you some examples below:

One of Chairman Powell’s remarks was that his personal outlook on the economy had strengthened since December. That is a good thing for everyone involved. Anytime the economy improves, everyone’s life is better. However, the immediate reaction was reflected by the stock market with a sharp move down almost 300 points and a rise in long term interest rates. Who would have thought that just a few words could be so powerful?

Everyone was so concerned by the rise of average hourly earnings for private sector workers in January, which increased by 2.9%. They missed several other points made by Powell. What nobody put into context was that there were numerous states across the U.S. that increased their minimum wage at the beginning of January. Also, no one factored in the effect of hundreds of thousands of bonuses given to employees due to the tax savings on income taxes. This is a prime example of traders reacting to news that they clearly did not understand, as both of these events were one time occurrences. What they failed to acknowledge is that Federal Reserve Chairman Powell stated subsequently that were currently no signs of wage inflation. Due to the overreaction from the first comment above, traders missed his point that even with the increase in wages in January (which is a good thing for everyone) the inflation cycle was not accelerating.

Most importantly, Federal Reserve Chairman Powell stated, “There is no evidence the economy is currently overheating.” To illustrate how traders perceived the same information, the market sold-off a thousand points over the next several days based upon the first quote without any concern or evaluation of the final two. So, what did happen as a result of new Federal Chairman’s comments? The news was inadvertently good. The economy has improved since December and wage increases are good, but do not add to inflation and the economy appears to him to not be overheating. A slam dunk of good news, but the market sold-off over a thousand points!

One of the common approaches used by hedge funds today is to use leverage in their investing portfolio. By virtue of borrowing against the equity of the fund, they use those borrowed funds to double up on their stock positions. One of the great lessons learned from the 1929 crash is the improper use of leverage. At that time, you could leverage a portfolio of stocks by 90%. For example, if you had $100,000 in equities you could essentially borrow $90,000 worth of debt to buy additional investments. That looks great when the market is moving up but is a disaster when the market is going down. Envision the great market crash of 1929 when the Dow dropped over 27% in a couple of days. In this example, your $100,000 portfolio after would be worth $73,000. However, your debt would remain the same at $90,000. As you can see, your portfolio would now be underwater and you would owe the brokerage house the difference. Whether it was actually true or not, the stories of investors jumping from their windows in 1929 seems plausible.

Wall Street has frequently used leverage to exaggerate portfolio returns. When the market dropped as fast as it did during February, it was reported that some hedge funds had used leveraged ETFs, and due to this strategy, closed down close to 90% during the month. As in 1929, leverage is great on the upside but can be devastating to your portfolio on the downside. This is one of the reasons why we, at Rollins Financial, do not use this leveraged approach. This is the difference between investing and speculation. We prefer to get rich the old-fashioned way, slower rather than faster.

Ava in Basics 4 Ice Skating

In the preceding week, President Trump announced that he would impose 25% tariffs on steel coming to the United States. In addition, he would recommend tariffs of aluminum coming into the United States at 10%. There was a huge market sell-off from traders, and the economists, universally, panned the idea as being borderline ridiculous. The financial market’s commentaries were universal in their disgust at such a proposal as well. And their reason, other countries would retaliate with tariffs of their own. They also assumed the tariffs would increase the cost of manufacturing in the United States, therefore, creating inflation which would be damaging to financial markets and interest rates.

First off and most importantly, we do not even know what products these tariffs would be applied. In addition, we do not know when they will be effective and which countries will be excluded. But there is a lot more to understand about tariffs than the simple definition used in context with imports.

Let’s examine exactly what happens when tariffs are applied. First and foremost, our steel in the United States does not come from China in great quantities. Less than 3% of the steel we import into the United States is from China. The vast majority of imports either come from Canada or Mexico. Over 25% of all steel imported in the United States comes from these two countries. Many believe China ships steel to Canada to import to the U.S. to avoid detection. A clear case of where sanctions are needed.

To think that either of these countries would not continue to import steel to the United States would be financial suicide for them. More importantly, maybe they would actually consider relocating their manufacturing plants to the United States. If you had a Canadian manufacturer that would only need to relocate a couple hundred miles south to be in the United States to overcome the tariffs, this move would not only be economically feasible, but a good thing for the U.S. economy. Might the proposal regarding tariffs be more designed to create a better economy in the United States rather than a detriment to imports?

One of the things I fully agree with from the President’s perspective on tariffs is that we cannot have a country devoid of steel manufacturing. Because steel is the component of so many items that we manufacture in the United States, we could never get into a situation where the country would not be self-sufficient in steel manufacturing.

Most of you probably do not remember the oil crisis in the early 1970s. I vividly remember it, and hope to never go through anything like it again. Due to the political issues of Israel and Saudi Arabia in the 1970s, Middle Eastern countries producing oil decided to boycott the United States. They were not going to sell oil in the United States due to the U.S.’s military support of Israel against Arab countries. The effect of this boycott was unbelievable. I remember getting up at the crack of dawn and standing in gas lines for close to an hour just to get any type of gasoline at all. Often times, after waiting and waiting, the gas station would run out of gas and all of your time would have been for nothing. The reason that these long gas lines existed was that the United States had no oil production sufficient to satisfy the needs of the economy. In fact, it created a national security crisis since our country could not operate without oil. The resulting effect, of course, was recession in the United States for several years and inflation that reached close to 13% during President Jimmy Carter’s years.

Consider the same for steel. Since we need steel to manufacture products in the U.S. such as automobiles, construction equipment, etc. what would be the economic fall out if we didn’t have any? If, for whatever reason, some countries decided not to sell steel in the United States, what would be the end result? The end result would be a massive recession in the United States, probably leading to depression. In addition, it would become a national security problem if we could not provide military armament in the case of war. In fact, the end result of not being able to produce steel in the United States would likely empower some evil country to try to use our economic weakness for their military superiority.

Okay so maybe I over-exaggerated the effect of not having steel. However, it is absolutely clear that we need more manufacturing of steel in the United States and we need it now. And there are many reasons why tariffs make sense. If steel manufacturing is being subsidized by a government and foreign countries, and then shipped to the United States for economic profits, that is not fair to American manufactures and should be offset with tariffs. Believe me, I am a huge advocate of free trade without government involvement. However, if you consider the extreme cost to ship steel, due to its extraordinary weight and density, there is no way you could manufacture it halfway around the world and sell it cheaper in the United States than steel manufactured locally. And if you disagree, well then I have some oceanfront property in Arizona to sell you. Without question, there is government subsidy going on, and free trade can only occur when the government is not a party to the transactions.

So rather than a 5% selloff in the market for the perceived evil of tariffs, maybe it would be better to wait and see what happens. It will not be easy to enforce tariffs with Canada and Mexico due to the NAFTA laws that are in place in both of those countries. And to assume that any country would retaliate with their own measures borders on fantasy. The U.S. is by far the strongest economy in the world and it is also the biggest consumer of these goods. Any country deciding to boycott U.S. products would be committing economic suicide. Anyone who believes that China would not sell to the United States as a result of these actions clearly does not understand where the strength in the Chinese economy comes from. With the U.S. being a major importer of goods from around the world, a simple tariff on a product so minute to the U.S. economy is not going to create either shortages or inflation. Therefore, I disagree with the economists that speak on the news - I think the threat of tariffs might just get the job done by forcing relocation to the United States.

I have mentioned several times that there is no reason to fear North Korea from a military standpoint. Several times over the past year the financial markets have been paralyzed with fear over the potential that North Korea could send a nuclear missile directly to the United States and create massive damage. As I have often explained, for the last 25 years, U.S. presidents have essentially “bought off” North Korea. President Bill Clinton approved massive funding of North Korea in order to slow down their nuclear development. President Georgia Bush also continued this funding to keep North Korea out of the highlights. President Trump elected to call their bluff. Basically, he said we are not going to give you any money to empower your military establishment. In addition, we will insist that China not continue to fund your oil industry and import products into North Korea. Did you actually understand the effect of this policy?

In the last two weeks, the winter Olympics was held in South Korea which is the mortal military enemy of North Korea. Low and behold the sister of Kim Jong was honored as the South Korean’s guest for this Olympics. In addition, athletes from North Korea participated in the events and their hotel stay was fully funded and paid for by South Korea. Even the headlines said that North Korea was seeking appeasement with South Korea after 70 years of hostile relationships. The one and only reason leading to this reconciliation was the economic sanctions placed on North Korea by the United States. Those of you that are skeptical of the power of economics over the power of military actions need to see this and understand its consequences.

So, to summarize, the month of February was not a good one. However, after 14 straight months of profitable investment months did you really think we would not have a down month? Investing will always come with its ups and downs but you have to evaluate the reasons for that volatility. Are the reasons based on real economic events or are they based upon the wide fluctuations created by momentum traders and hedge funds. I think the commentary above illustrates that the reason for the volatility in February was more on the latter rather than former. The one true economic analysis you could bring from the volatility of February is that if you have idle cash sitting around, it is time to invest it for future gains.

Valentine's Day 2018

As always, the foregoing includes my opinions, assumptions and forecasts. It is perfectly possible that I am wrong.

Best Regards,
Joe Rollins