Wednesday, April 3, 2019

Best stock market quarter in over a decade, and reflections on our first 40 years investing.

As we end the first quarter of 2019 you cannot help but be impressed by the stock market’s performance in the first quarter after the carnage from the fourth quarter of 2018. The stock market made a stunning turnaround to recuperate nearly all of the losses it suffered during the fourth quarter of 2018. Virtually all segments of the market were up, including the beaten down oil sector along with a sterling performance by technology. There is a lot of positive things to say regarding the economy and the markets, although it is often minimized by the negative talk regarding a slowing economy. As I have pointed out in the past, a slowing economy is actually a virtue in that it keeps worldwide interest rates low as earnings continue to prosper, albeit at a slowing pace.

I have much to talk about in this posting regarding the economy as well as some reflections as we approach our 40th year in business. I wanted to reflect on some of the events that led to our current thinking and a successful investment criterion. If you wanted the stock market to perform well, this would be the economic environment for it to do so. We are currently in a “goldilocks economy” with interest rates low, earning high and inflation contained. That is the trifecta of positive investment returns as I will illustrate below.

Eddie, Jennifer, Lucy and Harper
skiing in Utah

I also want to describe the growth of this investment thought pattern over the last 4 decades that led to positive returns. However, before I do so as I must always reflect on the performance of the financial markets for the first quarter and for the month of March 2019.

As we reflect back on the best quarterly performance in a decade, virtually all financial assets were up in this quarter. The Standard & Poor’s Index of 500 stocks increased 1.9% in March and is up a sterling 13.6% for the year 2019. Also, the one-year performance is up 9.5%, which you have to remember includes the disastrous selloff in the fourth quarter of 2018. It is always interesting to note that the 10-year average in this index is up 15.9% per year for the last decade. The NASDAQ Composite was the best index of the quarter, up 2.7% in the month of March and up 16.8% for the year 2019. The one-year performance is also up at 10.6% and the 10-year average is 18.9% per year. The Dow Jones Industrial Average, mainly due to the downturn in Boeing stock, was only up 0.2% during March, up 11.8% for the year 2019 and up 10.1% for the one-year period then ended. The 10-year average on this index is also up double digits at 16.0% per year for the last decade.

Even the downtrodden fixed income index was up during this period. For the month of March, the Barclays Aggregate Bond Index was up 2 % and is up 2.9% for the year. The one-year performance on the bonds are 4.6% and for the 10-year period they average 3.7% per year. Once again, you can see the huge differential in returns between equities and bonds as the above numbers indicate. One of the most important things you have to consider with a fixed income investment is the direction of interest rates. Today, we have one of the lowest 10-year bond yields of all time and if you were a betting person, you would almost bet that index was going higher rather than lower. If, in fact, the interest rates do move up with the good economy, it is almost assured that your fixed income investments will operate at a loss. From a standpoint of potential investment returns, clearly equities favor higher returns than fixed income, which will likely operate at a loss or breakeven over the rest of 2019.

As we go into the second quarter of 2019 there is much to reflect upon. There is no question that the earnings for the first quarter are expected to be somewhat lower. It is currently anticipated that earnings would fall for the first quarter by 3.8%, however that must be taken in context with the fact that earnings are at historic highs and a small move down would not lower the anticipation of another strong earning cycle. Also, earnings expectations have historically been minimized by earnings that have exceeded expectations by an average of over 5% going back to 2010. If that is truly the case, we would anticipate an earnings growth this quarter that is basically even with the prior quarter. During the last quarter of 2018, with all of the financial forecasters believing that recession was inevitable, earnings growth actually increased by 3.5%, which quelled these fears and led to a large turnaround in the first quarter of 2019.

We are also seeing other positive attributes that are leading to market gains. For reasons that are hard to explain, the 10-year treasury rate has fallen dramatically this quarter. Back in October 2008, the 10-year treasury was currently trading at 3.25%, dropping all the way to the 2.4% range we enjoy today. This dramatic decrease in interest rates will most assuredly lead to a rush of refinancing and purchasing of homes, which has slowed due to the higher interest rates over the last 6 months. Lower interest rates have a very positive effect on the economy, creating new jobs in housing construction, suppliers and all the retail outlets that cater to home upgrades and improvements.

It is also clear that the current administration is campaigning for lower rates to keep the economy growing, but honestly the markets have provided the lower rates which should do the work for them. Surprisingly, the economy enjoys a continuous low inflation cycle. Last Friday, the Federal Reserve’s favored inflation gauge, core personal consumption expenditures, rose just 1.8%. This percentage is well below their optimal inflation rate of 2%. But more importantly than that, with inflation well contained, the Federal Reserve should have no reason to increase interest rates at this point, which is positive for the economy.

As you know, the Federal Reserve has basically two mandates to keep employment high while keeping inflation low. At the current time, employment operates at close to full employment and inflation is well contained. Given that double mandate, there is virtually no academic reason for increasing interest rates for the remainder of 2019, which should lead to a strong economy throughout the year and a recession is highly unlikely. While the equity markets will certainly be up and down over time, the positive trend is clearly intact and while swings in the market are almost inevitable, the trend up is clearly in tact and should be even higher at the end of the year, than they are today.

As we approach the start of our 40th year in business in year 2020, I could not help but reflect on what has led to the successful growth in our business and the beneficial events in history that helped us grow economically with our investment philosophy.

Over the last two years, we have enjoyed national recognition that may be unprecedented for a relatively small local investment company. Many of these awards were not campaigned by us, but yet came through national recognition and public filings. We are honored to have enjoyed the following recognition over the last two years.

1. In 2015, we were acknowledged as the 20th best nationwide investment advisors by CNBC. At that time, we managed roughly $274 million in assets and today we have doubled in size to roughly $560 million.

2. In 2018, we were awarded as One of the 300 Best Advisors in the United States by the Financial Times.

3. We were nominated by Accounting Today as one of the 150 largest CPA firms in assets under management.

4. Recently, we were awarded one of the 11th best financial advisors in Atlanta by Advisory HQ.

All of these awards were greatly appreciated, but I think they acknowledge 40 years of hard work spent understanding financial markets and reacting to those markets in a positive economic way. Not to say we have not made any mistakes over the past 40 years, but hopefully we have learned from those mistakes and improved along the way. The history of the firm is centered on the financial aspects that control the investment philosophy of today. When you evaluate financial firms, many of them were formed recently without this economic backdrop. How many investment advisors can boast that they have gone from a firm started with absolutely nothing, to an award-winning one from a small office in Atlanta?

Joe and his first computer

I would like to reflect on the history of the firm from when I started it in 1980. In the prior years leading up to 1980 we suffered through the disastrous inflation-prone years of President Jimmy Carter. One of his principal advisors was Dr. Alan Greenspan, which I will comment on extensively as follows. I vividly remember waiting in long lines to purchase gas due to our support of Israel during the war in the Middle East. Today, we are no longer economically dependent on the Middle East for oil and technology, and open markets have led to a boom in oil production in the United States. As I began the accounting firm in 1980, just as President Ronald Reagan was taking office, interest rates soared and the economy was clearly in recession. It was certainly not the optimal time to begin a small tax practice, but sometimes crisis leads to opportunity.

In those days, I would send my best clients to people that I believed could help them financially. Oftentimes, I would refer clients to the largest investment houses only to suffer disappointment. I soon found that these large brokerage houses had way too many conflicts and they would invest in financial products that met their own financial goals, not my clients. The final straw for me was when a client was led by a well-known broker in town to invest in a real estate partnership which carried huge fees and unrealistic appreciation of the assets. When the project had completely failed a couple years later and my client lost his entire investment, I complained to the broker who had advised my client to purchase into this without my knowledge. His response was that the client was “a big boy” and he could have read the financial document himself. Once I recognized these conflict-laden practices were not in the best interest of my clients, I formulated the plan to invest my clients’ money myself.

This process began in 1987. During the Reagan years, the stock market had performed extraordinarily well as interest rates fell from their highs in 1982. Unfortunately, President Ronald Reagan appointed Dr. Alan Greenspan on June 2nd, 1987 and he immediately announced his intentions to begin increasing interest rates to slow the accelerating economy. These increases in interest rates had a very negative effect on Wall Street, leading to the market crash in October 1987 (when the market fell from a high of roughly 2,100 to roughly 1,700 in one day). This 22% decline was the largest one-day stock market crash of all time. This was certainly not the optimal time to consider an investment company. However, I have to reflect on that market that closed that day in 1987 at roughly 1,700 but today is 25,928.

I wanted to build a new kind of investment company where there would never be any conflicts of interest. It would be a firm where the client’s interest was always held at the highest level of importance and we would not invest money where we would be paid to do so, rather we would only be paid by the client. We would sell no commission products and would take no money from any source other than the clients, period. Since this was such a radical change from the common way big brokers worked, I knew it would be controversial to them. In addition, there would be no surrender charges, a client could leave whenever they wanted to and the only way we could make money would be to grow their account.

We were the very first CPA firm in the area to seek to create an investment company. At that time, the AICPA, which was the governing party of CPA firms, would not allow CPA firms to have investment companies because of the perceived conflict of interest. We received permission, but were required to do so as a separate company. Thus Rollins Financial was founded on January 1, 1990, as we are competing our 29th year in business with the investment company.

As I began my investment company, I went through many boom and bust cycles. I vividly remember when President George Bush refused to cut taxes to stimulate the economy which led to a recession in 1990, leading to the election of President Bill Clinton in 1992. I also remember the 1990s as being extraordinarily good for the stock market, except for the wild fluctuations and interest rates as Greenspan pushed the economy in one direction or another. In his famous speech in December 1996, Dr. Greenspan expressed his concern of “irrational exuberance” that forced the market down dramatically for a year or so. I also remember Dr. Greenspan’s paranoia about Y2K and his fear that all computers would not reset as the century turned, which of course in retrospect was ridiculous. I spent the night in New York City on December 31st, 1999 and awoke the next day to computers working the same as they did the day before.

Harper and Lucy Wilcox in Utah

Dr. Greenspan’s wild expectations of negative financial news in 2000 led to him flooding the economy in 1998 and 1999 with liquidity of unprecedented levels. This in turn led to the huge run-up in the dot-com stocks and a market in 1999 that was too hot. As was typical during the Greenspan era, in early 2000 he reversed course and drained the economy of liquidity and increased interest rates. This led to the final coup de grace in March of 2000, when the dot-com bubble burst. At that time, the NASDAQ Composite reached over 6,000 before falling to close to 1,000 a few years later. Once again, reflecting back, that same index today is valued at 7,729, but it took almost 18 years to exceed that level of March 2000.

While 2000 was a down economic year, nothing could have affected the market more than the 9/11 attacks in 2001. Once again, the market suffered huge declines and Greenspan cut interest rates to compensate for that decline. If he had maintained a normalized interest cycle during this time frame, maybe this selloff and the economic downturn after 9/11 could have been minimized.

During this entire timeframe we learned that interest rate cycles are the most important aspect of equity investing. In anticipation of a bad economy after 9/11, Dr. Alan Greenspan decreased interest rates in 2002 to a then low of 1%. In fact, at the beginning of 2004, Dr. Greenspan advised that it would be better that all home owners adopt variable interest rates due to the extraordinarily low rates. Once again, only a few months later, he began increasing interest rates that over the next two years would move from 1% to 5.25%. He increased rates 17 consecutive months.

There are many that argue that Dr. Greenspan was the architect of the 2008 real estate disaster. He believed that low interest rates would accelerate the economy and would expand housing. However, he was a stanch opponent of federal intervention of derivatives, which led to the high risk mortgages which we all know so well today. In fact, the increase in short term interest rates from 2002-2004 in many ways led to the foreclosure disaster that occurred in 2007. People who could afford interest rates on a variable rate in 2002 could no longer afford them in 2007. As would be the case, bankers borrowing money basically for free from the Federal Reserve could loan it out for higher interest rates and make a large profit. What they did not count on, which was the single most important component of the 2008 disaster, was that the Federal Reserve would continually increase the interest rates to make the homes no longer affordable for the homeowner.

Dr. Greenspan remained Chairman of the Federal Reserve for 16 very volatile years. He often said that most of his economic analysis occurred when he sat in his bathtub with his yellow pad and thought deeply about the economy (it is best to avoid the visual aspects of that thought). What it actually led to was almost two decades of huge swings in the equity markets by an uneven Federal Reserve policy. During this time, we learned a lot about how the market moves based upon interest rates and the economy. I think this learning cycle has served us well in investing at the current time.

Fortunately for us, Dr. Greenspan retired in 2006. Since that time, we have seen a stabilization of interest rates and their movements to the market. Yes, we incurred the huge down move in 2008, but that was clearly at the hands of Dr. Greenspan and his prior administration. It appears to me that Federal Reserve Chairman, Jerome Powell, is of high credibility and knows exactly how to control the economy by gradual moves in interest rates to keep the economy at a high level.

The biggest benefit we have going forward is that the economy is strong and if the Federal Reserve stays out of the way, the economy should grow as we go forward. There is absolutely no reason why we should go from boom to bust as often as we did under Greenspan if the Federal Reserve does their job efficiently. At the current level of basic full employment, the economy should grow in the 2-3% range for years to come. However, any intervention to increase interest rates is likely to disrupt that normalized growth. Hopefully the current members of the Federal Reserve understand this and will leave the economy alone to grow its own foliage.

All of us should feel encouraged by the technology that is changing virtually every aspect of our lives. They did not find a better way to drill oil to turnaround the oil industry in America, they instead discovered that technology could allow them to find oil and allow them to drill it more efficiently than any other developed means of bringing oil to the surface. Technology led to oil wells that never before existed. Due to fracking and shale oil production, the U.S. is now the largest producer of oil in the world. In the 1980s and 1990s we begged the Middle East to sell us oil; we no longer need to do so.

There is also a technology that is changing the natural gas industry. Today we are able to liquefy natural gas and ship it around the world. Huge liquefied gas manufacturing plants are currently under construction near the Gulf Coast, which will take very cheap natural gas from the south, liquefy it and ship it to Europe and China to sell it cheaper than their current supplier.

President Trump was very critical of the fact that Europe acquires most of their natural gas from Russia. He understood the national security concerns that having natural gas being supplied by a potential enemy could have devastating effects on the European economy. But now, the U.S. can ship natural gas into Europe and sell it for cheaper than they are currently buying from Russia. There is a change occurring that is unprecedented in economic cycles.

I remember back only a few years when the so-called forecasters were predicting that robots would put many people out of work and take jobs from Americans and run them with machines. Today, in the automobile industry, robots manufacture the majority of a car, but yet employment remains full. Technology has changed the way that cars are produced and they are better than ever with fewer defects and higher reliability. I remember often times buying a new car and taking it to the dealership the day after purchase with a long list of defects. The car I currently drive has never been to the shop in over 2.5 years.

Now we are enjoying the electrification of cars and the potential it holds. Electric cars are common now, which get long range and do not use fossil fuels to drive. Clearly, they have their limitations, but it is my projection that within the next 10 years, every car manufactured will have electric features that will change gasoline consumption forever. Cars today have electronic features unthought-of only a few years ago. Electric censors in cars keep you from backing into your neighbors’ tree and stop you short from running over people. These features make the cars so much safer nowadays than they were only 5 years ago. It is quite unbelievable.

So, in closing, I reflect back on these 40 years and see all that has changed. Yes, there are problems in the world that will make us adapt our thinking. There is no question that the deficits will have to be addressed, but not immediately. The strength of the economy reduces billions in taxes, but we have to be able to afford the entitlements that we enjoy in America. Very small changes in the Social Security system could make Social Security solvent for 100 years. However, until we have a congress willing to support any changes in that law it is not likely to occur any time soon. But technology is changing everything we do and making our lives simpler and better. The reason I am optimistic for the economy and the stock market is that I see that huge companies generate a substantial portion of their revenue not with people or manufacturing, but through services. These services are extraordinarily profitable and their stock will be rewarded.

CiCi and Ava

The one negative aspect of stock market investing is that the only clear indicator of a down market is if there would be an oncoming recession. A recession will almost always reduce the value of the markets due to the lower earnings of the corporations. Fortunately, with lower interest rates in place, higher earnings and inflation intact, any recession is likely 2 years away and, if the Federal Reserve does its job, maybe even longer than that.

As always, we encourage you to come in and visit with us and discuss your goals and financial plans. If you are interested in discussing your specific financial situation, please feel free to call or email.

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

Best Regards,
Joe Rollins