Tuesday, September 10, 2019

Standing Ovation at Vanderbilt University

Since there was not a whole lot of news in the financial markets during the month of August, I thought I would tell you about the time I received a standing ovation at Vanderbilt University. I will not share the details yet, rather just force you to read all of this other important information before you get there, but I think that you will be entertained. There are very few times in your life when you could receive a standing ovation from 14,000 people in an arena and not be appreciative. I think you will see that the ovation was totally warranted.

I also want to cover some other areas in this posting that I find interesting and I hope you will too. I continue to marvel at the flood of misinformation that is available everywhere today. I am almost of the opinion that constitutes a conspiracy of fake news more to embarrass the President than to educate investors. I want to cover some items that I think are important and you should evaluate. I also want to discuss the investment quality of bonds at the current time with the extraordinarily low interest rates we are enjoying. All of this new and exciting information follows, but now I must cover the financial markets for the month of August 2019.

Ava and Josh with the Statue of Liberty

As most of you know the month of August is a slow trading time and historically one of the worst trading months of the year. The month of August 2019 really was uneventful for the most part. The Standard & Poor’s Index of 500 stocks was down 1.6% for August, but continues to be up 18.3% for the year 2019. I would like to point out that this S&P 500 index had been up an average of 13.4% for the last 10 years. The NASDAQ Composite was down 2.5% in August and up 20.9% for the year 2019 and averages 16.1% for the ten-year period. The Dow Jones Industrial Average was down 1.3% in August, up 15.1% for the year 2019, and up annually 13.6% for the last 10 years. The Barclay’s Aggregate Bond Index was actually positive in August, up 2.6%, for the year 2019 it is up 9.1% and it has average annual returns of 3.9% over the last ten-year period. As you can see, each of the major market indexes performed roughly 4 times the bond index over the last decade.

I watch the major financial television news every day and am often amused by either the lack of veracity or the distortion of what they are reporting. When the short-term yield inversion occurred recently, the commentators were almost breathless in their explanation. Never have I seen such hysterics over such a totally meaningless financial occurrence. While we talk about the rate inversion, what we are really talking about is when the two-year treasury interest rate exceeds the interest rate of the ten-year treasury. It is quite an unusual time we have now where we have a one-month treasury yielding 2% and basically a 30-year treasury yielding less than 2%. So basically, you could buy a bond for one-month and make 2%, or you could buy a bond for 30 years and make roughly 2%. Does that make any economic sense to anyone?

Think about it just for a second. If you believe, as I do, that inflation will average roughly 2% for the next generation, why would anyone buy a 30-year bond yielding basically the rate of inflation? By basic economics alone, that bond would generate in real dollars no gain to you for the next 3 decades. Couple that with the fact that currently there is over 13 trillion dollars in European and Asian government bonds that have a negative rate of return. Basically, in Germany you could buy a $10,000 treasury bond and at the end of 10-years they would return $9,800 to you. I am trying to illustrate the absurdity of the situation and question why any informed investor would make that choice.

As I have explained in these pages before, a great deal of why the U.S. has such low interest rates is that the rest of the world is actually lower. If all you could get in Germany was a negative rate of return, you would certainly be better off invested in the United States where you would get some rate of positive return rather than negative. As the money rushes from around the world to buy U.S. treasuries, of course it deflates their currencies and increases the U.S. dollar. While many Presidents exploit the advantages of a strong dollar, in fact, economically it is not desirable. Since exports are overpriced and imports are underpriced, a high dollar actually leads to negative sales in the United States, which is not a good thing.

I read an interesting article that seemed to make a lot of sense in these crazy economic times about interest rates. Since 1976 there have been five significant yield inversion periods and in each case a recession followed. As is true in so many cases regarding financial matters, so-called experts quote the past to explain the action. I almost laugh out loud when I hear commentators quote on major news programs what happened in 1937 as compared to today. Surely no informed commentator would quote a period of time during the Great Depression as a comparison to the economic explosion we are enjoying today, but I digress.

I reiterate often in these postings that you cannot evaluate an economic event unless you understand everything that is going on around it. So why would five previous rate inversions be informative information in determining what might happen today? The reason is clearly documented by history. As quoted in these articles, during those five previous historic periods there was a spike in oil prices that drove up the price of crude oil by nearly double. As you can clearly imagine, if you doubled the price of oil over a relatively short period of time, the fear of inflation would be paramount. Oil impacts nearly everything in our lives including utilities, cost of transportation and the cost of goods. The doubling of oil prices clearly would lead to higher inflation.

The Federal Reserve has basically two mandates that it must adhere to. One is that it must control the rate of inflation and secondly, it must try to maximize full employment in the United States. As the price of oil doubled, the Federal Reserve would, by necessity, have to increase interest rates to slow the growth of inflation. So, in each of these five previous times, what you saw was an increase in interest rates to slow the economy which almost assuredly had more to do with the recession than the economy itself. If you compare that time to where we are today, it is clear to see that the financial circumstances are not similar. In our case today, the Federal Reserve is clearly trending with lower interest rates, not higher, and more importantly the price of oil has declined dramatically in recent years from previous levels. So, while the inverted bond yield might be informative to you, it clearly does not test the current economic circumstances. What we have today is dramatically different than we have had in previous bond inversions and, therefore, it makes no sense to assume a recession would follow based upon this economic indicator.

However, that did not stop the financial news from anxiously repeating this multiple times a day. If I’ve read one article about the upcoming recession, I’ve read them all. In fact, I noticed the major financial publications picking up on this projection, including major headlines reporting how you invest in the upcoming recession. What recession?

Let me give you an example of a very well-known financial person who, in my opinion, is a reporter of fake news. Ray Dalio is one of the most famous hedge fund managers in the United States, and it is reported that his personal net worth is somewhere in the $20 billion range. That is not chicken feed, even among rich people. While well respected as one of the best hedge fund operators, is he really trying to project financial activity, or is he a keeper of fake news? During a strong economy in February 2018, Ray Dalio caught everyone off-guard when he said that there was a 70% chance for a recession prior to the election in 2020. Since the call was greater than 50%, he was basically saying there was more likelihood than not that a recession would occur over the intervening 20 months.

Lo and behold, one year later in February 2019, Ray Dalio reduced his forecast of recession prior to the 2020 elections to 35%, and then in August of 2019 increased this prediction to 40%. It was unbelievable the amount of words that were spilled on national TV regarding these projections. As I watched commentators almost foaming at the mouth to explain the upcoming recession, I could not help but to reflect that even if Dalio was correct that there was a 40% risk of recession before 2020, did it not mean there was a 60% chance that there would not be a recession? It just never occurred to these commentators to report the inverse. As I am reminded by many media clients that I represent, “if it bleeds, it leads” I guess I should not have suspected otherwise. However, it is still unfortunate that investors are not given both sides of the argument.

I had a call last week with a client who indicated he was having trouble sleeping at night because he felt his portfolio was not performing well so he wanted to move to bonds. This statement caught me somewhat off-guard given that not only was it inaccurate, but clearly the client had not been observant of the financial markets. In the first part of September, the S&P 500 index is trading up to almost 20% and is 2% from the all-time highs. How anyone, for any reason, could believe that we are having a bad year in 2019 is mindboggling.

Reid and Caroline Schultz at sunset

As I continued to explore this conversation with the client, I tried to point out that we are in a time of historically low interest rates at a time when the financial economy is quite strong. I pointed out that the 30-year treasury is now trading at the lowest level it has ever traded at in the history of American finance. While this rate may stay low for a while, more likely than not, the next move on the treasury rate will be higher. If you are not aware how bonds trade, when the interest rates go up, the bonds go down in value which is not a good thing.

I also pointed out that the dividend yield on the S&P 500 today is almost 2% while the ten-year treasury yields 1.5%. It is rare indeed when the dividend yield of stocks is greater than the highest treasury rate quoted. Basically, that means that from dividends you can make more with the 500 index than you can make with a ten-year treasury. If you go about the calculation in a more basic manner, the S&P is currently valued at 18 times the projected 2019 profits and if you use the inverse of the price/earnings ratio, that implies a growth rate of 5.5%. Would you rather have the potential growth rate at 5.5% or the ten-year treasury rate at 1.5%?

As I explained to the client, there is no question that stocks are volatile and they go up and down, but over time, as illustrated in the comparison above, stocks make three or four times the returns than bonds will ever return. Now that we are sitting on the lowest interest rates ever in the history of American finance, could we reasonably expect rates to fall further or might they go up? Contrary to popular opinion, bonds can, and in fact do, lose money. Just to give you a normal example, on the average the 30-year treasury should be yielding roughly 3% greater than the ten-year treasury. If the ten-year treasury today is at 1.5 then the 30-year treasury should be yielding 4.5%. The reason for this is quite obvious. Over a 30-year period you take substantially greater risk of inflation, earnings and the economy. While a ten-year period is long, a 30-year is a large portion of a person’s lifespan. As an example of exactly how great the risk is, if the 30-year treasury would move only from 2% to 3%, which it was yielding in the fall of 2018 (roughly one year ago today), the value of that 30-year treasury would fall by a stunning 20%.

Just to give you a quick example of the value of stocks compared to bonds around the world, just consider the following information. In the United States, the ten-year treasury yields 1.56% at this writing. The dividend rate on the stock market currently is 1.92%. In Germany, the ten-year treasury yields a negative 0.6% and the dividend rate on their stock market is 3.29%. In the United Kingdom, the yield on a ten-year government bond is 0.59%, while the dividend rate on their stock market is 5.13%. I am not sure how many words or times it takes to emphasize that, fundamentally, the potential for higher interest rates is more likely than not and therefore bonds constitute a significant risk portfolio.

I noticed over the weekend that there were numerous articles written about the future of Social Security and how it would impact your retirement. Throughout my lifetime we have been discussing that Social Security is clearly going to run out at some point and adjustments need to be made. Well, I find that assertion absolutely absurd since I am 100% positive that would never occur. Clearly the General Treasury would step in and make Social Security sound, but there is no reason for even having this discussion. I cannot help but think that this discussion is paramount only for political reasons and not by economic sense. I am not going to bore you with how easy it would be to correct Social Security for generations to come since that discussion even bores me. I can only tell you that many learned economists have expressed the opinion that the issues with Social Security could be solved over the time it takes to drink a cup of coffee at breakfast. However, politically no one will have that discussion.

I was thinking back to a political rally I went to in 2004. I was invited to the old Civic Center auditorium to hear then President George Bush speak about privatizing Social Security. His mother, Barbara Bush, was present as were other distinguished people whom I do not recall. Basically, the President’s contention was that if we were to privatize Social Security, allowing a portion of those funds to be invested in equities rather than treasury bonds, the long-term benefits to Social Security recipients would be huge and the effect would dramatically reduce the cost to the taxpayers.

Joe and Ava

The reaction to President Bush’s suggestion was preposterous. You saw one politician after another almost foaming at the mouth to describe how absurd that proposal actually was. None of them cited Chile and the effect privatizing had on their Social Security system, which essentially made it self-sustaining. All they could warn the public about was that Social Security should not be invested in equities. I never really hear anybody comment on that today, but are you not a tad bit interested in what the effect would be? What if your share of Social Security had been invested in an index, such as the S&P 500 over the last 15 years, when Bush first made the proposal? How would your Social Security dollars have grown during that 15-year period if you had done just as George Bush had said?

Of course, any time we discuss investing, larger investors bring up the period in 2008 when the S&P index was down 38%. They give you that example to scare you of the potential risk that occurs in investing. They never actually bother to point out that of the last 16 years the S&P 500 index has been up 14 of those years. It is a fact that there are more up than down years in investing.

Just to give you an example, over the last 15 years the S&P 500 index has averaged a positive 9% per year. During that same time frame, the Barclays Aggregate Bond Index has averaged less than half of that per year. I want to point out that the last 15 years includes the 2008 stock market downturn. So basically over this 15-year period, including the stock market correction, if you would have had your Social Security dollars invested in equities rather than in treasury bonds, your returns could have been greater than they are today. This is even more compounded by the fact that treasury yields are so low today that, in the history of these investments, your future Social Security dollars are getting even less returns than ever. I often wonder to myself exactly where the Social Security system would be if privatization would occur. I think the record is fairly obvious that everyone would be receiving more Social Security today if invested in equities rather than bonds. I also think it is fairly obvious that the long-term financial stability of the Social Security system would be greatly enhanced, but you are missing one of the most important components of Social Security that is never discussed.

If the Social Security system were ever privatized or turned over to other people to invest, the politicians would lose control. In fact, they would not be able to dictate the future of your retirement, nor could they threaten you or warn you regarding the repercussions of any other choice. The reason the Social Security system will never be privatized in America is due to the stupidity of Congress itself. In so many ways, so many times a day, you hear such extraordinarily bad economic judgment coming out of Congress that I hope we all know now to consider any type of news coming from them worthless. There is no question that the Social Security administration should invest in equities for the betterment of all retirees. It can be a slow process of investing 10% per year for 10 years and everyone would have the option to do so or not. There would not be an option to take the money out or to spend it; it would be exactly how it is today except the returns on those investments would quadruple. I guess it is so simple to understand that it defies imagination and cannot even be discussed by politicians.

Okay, so I have teased you about my standing ovation long enough, so here is the full story. When I was playing basketball at the University of Tennessee, everything was new and exciting to me. Once we played in the old field house at Auburn University; it was so cold that there was actual ice on our clothing after practice. Fortunately for everyone, that building eventually burned down. One of the most unusual games we ever played, and where I received my first standing ovation, was at Vanderbilt University. You have to realize that this was in 1968, when not much local basketball was carried on TV and the quality of play was not particularly good. When I played there were only white players in the SEC. As this changed, I recognized I did not have the skill set to play the game and I retired to more exciting things like accounting and finance. My idea of fun is different than most.

The Memorial Gymnasium at Vanderbilt University is one of the more unique basketball venues for basketball. It was built in 1952 and has a seating capacity of roughly 14,000 people. Who would have ever thought that growing up in a small rural town in Tennessee would afford me the opportunity to receive a standing ovation at such a renowned basketball venue?

The gymnasium has one very interesting feature. For reasons unclear to me, approximately the first three rows of the stadium actually sit below the level of the court. And the most unusual feature of all is that the benches for the players are not along the side of the court as they are in most gymnasiums. The actual benches for the teams are located at the end of the floor, which makes it unusual given that it takes a considerable amount of time to get to them if timeout is called and you are on the opposite side of the court. I believe that configuration with the benches at the end of the court may be the only major gymnasium in the United States where it exists.

I should have known that we were immediately in trouble when we came out for our pregame practice. At the University of Tennessee, we had this very elaborate warmup that had people running around in all different directions, but ended the layup line with somebody dunking the basketball at the court. As would be the case, as we were warming up someone kicked the basketball and it rolled off the court. It was the only ball we had. Since the ball rolled into the student section, they continued to throw it back and forth, preventing us from warming up. Much to our chagrin, the gymnasium was already completely full. The actual ball finally tended up in the upper deck before it was recovered by security and returned to us. However, in the meantime we lost about half of our warmup time.

That year the University of Tennessee football team was scheduled to play in the Orange Bowl after Christmas, and I am relatively sure the Vanderbilt student section attending our basketball game had partaken in some holiday cheer prior to arrival. As we were warming up, very large oranges were thrown from the upper deck - exploding like bombs on the court. As you can readily imagine, our team was anxious to avoid the projectiles, but the mess it made on the floor was somewhat overwhelming. The effect fresh orange juice has on a slick hardwood floor can be a little scary and none of us wanted to slip and slide during the pregame warmups.

My claim to fame came halfway through the second quarter. I went up for a rebound in a heavily congested area and one of the Vanderbilt players hit me with an elbow. I went to the ground, stunned by the blow, but when I looked up the whole team was on the far end of the court and there I was all alone. I had put my hand over my mouth which became immediately covered in blood and I knew something was wrong, I just did not know exactly what or how bad.

Josh and Ava in Central Park

After losing consciousness for a second, I then realized that someone had called timeout and I was literally there all alone under the basket, with blood pouring out of my mouth and down my jersey. I began to head towards my teammates on our bench, which was of course on the exact opposite end of the court where I stood.

I looked around again to try and determine where I was and where I should be going and began walking rather gingerly across the length of the court in my blood-stained jersey with my hand over my injured upper lip which would soon require 6 stitches.

To my surprise, almost 14,000 people stood, giving me a standing ovation. Not having gained total consciousness, I was not able to fully grasp what was going on at the time but I have to admit the thunderous applause and roar of the crowd was surreal. What a glorious feeling to have a standing ovation such as this when you are only 19 years old. Only later did I consciously understand that the standing ovation was not for me, but rather for the guy that hit me. However, at that age you will take any acknowledgement you can get.

On that note, come 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