Everyone loves a great conspiracy theory, I have one...

There is no way to put it mildly – from a financial standpoint the month of October 2018 stunk. I never want to minimize a downturn in the financial markets since people lose money, but this one defies the imagination. During the month of October, the NASDAQ had its worst month since October 2007. I intend to illustrate how completely implausible that correlation is. In addition, I also want to point out the astonishing positive economic evidence that forecasts that the markets will, in fact, recover and soar to new heights shortly. With such overwhelming favorable economic news, how the market can sell off in such a pronounced fashion is mind-boggling. Perhaps I have the answer in the form of a conspiracy theory, backed up by hard economic evidence.

Before I launch into that far-reaching and most interesting explanation, I have to cover the dismal economic performance of the financial markets during the month of October. The Standard and Poor’s Index of 500 stocks sold off to the tune of -6.8% during the month, yet it is still up 3.0% for the year 2018 and up 7.3% for the one-year period then ended. The NASDAQ Composite showed a dismal performance of -9.2% during the month of October but is still up 6.7% for the year 2018 and up 9.8% for the one-year period then ended.

The Dow Jones Industrial Average lost -5.0% during the month of October, yet it remains up 3.4% for the year 2018 and is up 9.9% for the one-year period then ended. If for any reason you thought that you would have been safe in bonds during the month of October, they also lost money, but at a much lesser percentage since they were down -0.7% for the month of October, but they remain down -2.5% for the year 2018. For the one-year period ended October 31 2018, the Barclays Aggregate Bond Index is down -2.1%.

There is just no way to sugarcoat the performance during the month of October, it was just downright terrible. What is fascinating about this performance is that it is not based on economic evidence but rather on the fear that the Federal Reserve is out of control and lacks the common sense to stop the hike in interest rates. I find this perception, that the Federal Reserve does not understand the impact of higher interest rates, both naïve and totally misplaced. I hope to better explain this matter below.

Caroline and Reid Schultz,

with Ava Rollins

Ava Rollins

Ava and Dakota Rollins at the beach

I have written about my father in past postings, but this month brought to mind a very important lesson that he taught me long ago. As I pointed out, my father was brilliant in many aspects. He had a master’s degree in electrical engineering from the University of Tennessee, but had the misfortune of graduating during the Great Depression in the 1930s and was unable to find work. He had drifted into the ministry and remained there the rest of his life. However, I was always amazed by the broad range of subjects that he spoke of and the knowledge he held on virtually all of them.

One of the things I always marveled at was his ability to give his sermons each Sunday almost seemingly without notes. He did, however, maintain a black book that contained sermon notes throughout his entire career in the ministry. When I was in high school, I would sometimes sneak into his office to read the black book. Each sermon was noted by the date and the church where it was given, going back close to 40 years. What was amazing to me was that there were only three or four items actually noted, including a simple phrase or two as a reminder of what to emphasize.

As a preacher, my father was a very dynamic and forceful speaker, but removed from his element, he was not one for small talk. We never had conversations about his profession, except the one day when I caught him in a rare moment of reflection. I asked him how he was able to give a 45-minute sermon based only on the three or four notes in his sermon outline and I will never forget when he replied, “Someday, you too, after 40 years of experience, will know what to say from only a few notes.”

I guess I have to admit that after 40 years of analyzing the financial markets, you find out fairly quickly what is important. You cannot allow yourself to be influenced by all of the talk on the financial news and the predictions of financial chaos that show up in the headlines on a daily basis. You must rely upon what you know about the economy and finance rather than hollow headlines that reflect bias in one direction or another.

This leads me to the great conspiracy theory for October 2018. It is interesting that as indicated in my blog last month , we had just finished the best quarter in the financial markets since 2013. We also reported the lowest unemployment rate in 49 years. How with such sterling financial performance could we suffer the worst market pullback since 2007? Perhaps I have the answer.

It has been long perceived that the month of October is bad for stocks. However, it is not typically the worst month of the year, as September claims that unique negative recognition. However, over the years there have been many noted downturns in the market during the month of October and as we were heading into the month, all of the negative forecasters were pointing this out. Of course, there are a lot of negative headlines surfacing with the midterm elections coming up, along with problems in Italy, Saudi Arabia and other parts of the world. But the principal reason for my opinion focuses on an interview given by the Chairman of the Federal Reserve, Jerome Powell, which coincidently occurred on October 3, 2018. In an interview with PBS, during an offhanded Q&A session, he said the following: “The really extremely accommodative low interest rates that we needed when the economy was quite weak, we don’t need those anymore. They’re not appropriate anymore. Interest rates are still accommodative, but we’re gradually moving to a place where they will be neutral. We may go past neutral, but we’re a long way from neutral at this point, probably.”

With those words, the perception of the investing community was that this Federal Reserve Chairman was totally out of control and would increase interest rates regardless of the economic circumstances at that time. Despite inflation being very well contained and the economy strong, but not overheating, would this new Chairman of the Federal Reserve increase interest rates to the point where the bond yield would become inverted and create a recession in America? This actually happened in 1987 when the newly appointed Chairman, Dr. Alan Greenspan, did exactly that, creating a loss in the stock market of 22% in one day, which coincidently occurred in October 1987.

This point centers on my conspiracy theory! For the last several years, the performance of hedge funds and institutional investors has not kept up with the overall market. The hedge fund industry, which performs well in the down markets, isn’t much of a performer during the up markets. Is it possible that they, as a group, decided that it was appropriate to move the market down, even with such great economic results, in order to improve their performance for 2018?

Joe and CiCi studying the stock market

What seems strange about this sell-off was that it occurred virtually at the beginning of October and ended almost instantaneously during the last couple trading days of the month. There is no question that the momentum traders also participated in this sell-off. As the market continued to fall and support was broken at the 200-day moving average, the momentum traders kicked in their algorithms, which indicated that the market would trend down instead of up, and selling was exaggerated. I have often wondered if many of these momentum traders and hedge fund investors meet up and make a decision to buy or sell as a group. It is like a game of chicken as they short the market as a group and then wait and see who should cover their shorts first. In either case, the market went down without any common logic during the month of October and we all sustained losses because of it.

So, what do you do in the face of these overwhelmingly negative financial markets? The only thing I know to do is to take my father’s advice and use my 40 years of watching financial markets to predict the future. As I have pointed out in so many postings in the past, there are basically only three things that control whether the markets go up or down; the economy, earnings and interest rates. Last Friday the unemployment report came out for the month of October and it showed that there were 250,000 new people added to the payroll during the month, well above any consensus estimate. The unemployment rate remained at 3.7%, the lowest rate since December 1969, the best in 50 years.

But the absolute crushing number was the over 711,000 new people added to the payroll and over 600,000 of those new entries into the employment market found jobs. As I have pointed out many times in the past, the secret of the economy is keeping people working. More people working means more people paying taxes and more people contributing to the economy. Right now, there are more people employed in the United States than ever in our history. Did you realize that over the last one-year period the unemployment rate has fallen close to ten percent? There are close to 3 million more people working in America today than were working only one year ago. These 3 million people support 10 million Americans.

It was recently reported that the GDP went up 3.5% during the quarter ended September 30th. It is currently projected that the GDP for the fourth quarter of 2018 would be in the 2.5%-3.0% range. While not as high, certainly more than acceptable. When you compare that the NASDAQ was down the most since October 2007, you need to review your history. In October 2007 this country was in a major market meltdown. The GDP for that quarter was down -8.2% in 2007 as compared to up 3.5% in 2018. First time unemployment applications in 2007 were in the 800,000-900,000 per month range, as compared to 2018, where employees are actually being added.

You may not recall this, but there was a time in 2007 when the Federal Reserve had to guarantee the money market funds since it was suspect whether those funds would be able to even return the money to investors. The entire country was in a financial meltdown, with foreclosures dominating the news. You compare that horrendous economic performance to 2018 when the economic evidence could not be greater and you just cannot fathom how the markets could report negative numbers. Therefore, my analysis is that the economy is great and strong and certainly there are no recessions in sight during the next couple of years.

The next major component of determining market value is earnings. In order to reassure myself regarding earnings, I went back and looked at the increase in earnings over the last several years. For the year 2017, S&P 500 earnings were up 24%, it is estimated now that earnings in 2018 might be up 22% when finished. Projected earnings for 2019 are certainly slowing, since there will be no tax changes in 2019, yet they are still projected to be up 11%. The increase in earnings therefore has been 57% in the last 3 years. On a compounded basis that is 68%. Wow! What is even more interesting is that as these earnings continued to go up, contrary to the market reaction in October of 2018, the price/earnings ratio has actually gone down. For the last 25 years the Standard & Poor’s Index of 500 stocks has had a price/earnings ratio of 19.2, on average. As we currently stand, the price/earnings ratio is at 18. So, for anyone to tell you that this market is expensive relative to prior years is basically expressing their uninformed opinion.

The earnings for the third quarter of 2018 were nothing short of spectacular. However, I still hear all of the financial commentators and their terribly misinformed views on such. I think it is important to understand the direction of earnings but I also think it is important to understand absolute earnings. When you see stocks you have never heard of go up 20% or 30% in a day based solely on showing a profit you have to evaluate the actual level of those profits before you invest. To express how misinformed financial information can be, let me give you a real-life example of the earnings report from Berkshire Hathaway. For the quarter ended September 30th they reported excellent numbers wherein they earned $6.88 billion in operating earnings (not including financial gains), which was basically double their earnings of $3.44 billion last year. As I watched this commentary, one after another so-called “expert” expressed his and her opinion on the quarter and one, Bill Smead, said “This is absolutely one of the greatest quarterly earnings reports that have ever come out of a United States corporation.”

I reflected on that for a second and compared it with the report the previous day from Apple. As all of you know, that stock sold off close to 7% this past Friday due to so-called negative earnings reports. I saw one commentator after the other criticize the company and its earnings report for close to three hours, citing their financial knowledge on the financial strength of this company. However, after closer inspection I found out that Apple reported an earnings report for the quarter of $14 billion and is by far the most profitable company in the United States - and probably the entire world. Even social media outcast, Facebook, showed a profit of over $5 billon for the quarter and they have no tariff restrictions. Certainly, Berkshire Hathaway profits were excellent, but to refer to them as the best ever demonstrates the bias that financial news brings.

So the first two components, the economy and earnings, both are beyond excellent and frankly are trending higher. Which leads us to the most important component that affected the markets during October – interest rates. Is it possible, that the Federal Reserve could be so inept as to increase interest rates in the face of an economy so strong that it would turn it into a recession essentially overnight? I am amazed that investors and commentators would be so naïve to think any politician would take such action knowing the dire consequences.

I question whether interest rates are even high today, much less too high to destroy the economy. The Federal Reserve has basically two mandates. The first mandate is that it is to keep employment high so that the economy remains strong. The other mandate is that it must control inflation so as the inflation does not get out of control. Based on the information above it is clear that employment is high, in fact, it is at the highest level in 50 years. Clearly, that mandate has been satisfied by the Federal Reserve. The more important component is whether the Federal Reserve is doing its part to tame inflation. I would argue at the current time that interest rates are not high at all. At the current time the inflation index reflects a current reading of 2.17%. If you compare that with the target on the federal funds rate which is set at 2.2%-2.25% you will note that the actual interest rate after subtracting inflation is essentially zero. Rather than expressing alarm, just consider that for a minute.

In order for a saver to actually earn money, they must earn in excess of the current rate of inflation. If you invested money today at a rate less than the inflation rate, then at the end of the term, whatever that may be, you would have actually lost money. If the Federal Reserve would intend to keep the interest rates in line with inflation, then at all times it must be trading above the current rate. If the Federal Reserve was attempting to slow the economy, the current rate would be at least double the current inflation rate. If you saw a federal funds rate that was 2% points higher than the rate of inflation then you would know that it was a concerted effort by the Federal Reserve to slow the economy. Since we do not currently see the Federal Reserve interest rates exceeding the rate of inflation, to argue that the Federal Reserve is attempting to restrict the economy is just uninformed. We may get there in the future, but we are currently not there today.

So, based on my 40 years of experience in this business, during the month of October we did virtually nothing. The three major components of higher stock markets were all firmly in place. The economy was great, earnings were high and accelerating, and interest rates restrained. Therefore, nothing financially led the markets lower. Whether it was a concerted effort on the part of professional traders or just an over exaggeration of the current political environment, I really do not know. The only thing that you can do when in doubt is invest with your experience, and that experience led us to do nothing during October.

We also know that historically the best months of the year are November through May and I would continue to expect the market to move higher after the midterm elections and reach my year end goal of the S&P at the 3,000 level, which is approximately 9.2% higher than it is today.

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

Best quarterly stock market since 2013!... Lowest unemployment rate in 49 years... It just does not get any better than this!... Why are Americans feeling so bad?

As the economy continues to post exceptional numbers and the major market indexes have reached new highs, I am still completely baffled by the absolute negativity exuding from the American population. Rather than out in the streets celebrating an extraordinary economy and the continuation of impressive corporate earnings, all you hear are negative comments that, to me, appear irrelevant to the big picture. So, I thought I would devote this posting to addressing your concerns by providing you with all of the positive economic information out there which should allay your fears.

As always, before I begin, I need to report the results of the month and year on the major market indexes. Although the performance for the month of September was flat, the performance for the quarter was the best in over five years. Many of you have heard of the old Wall Street saying, “sell in May and go away”, well that was not evident this year as the third quarter of 2018 was nothing short of spectacular.

Ava ice skating

Joe and Josh at a Braves playoff game - Braves won!

Ava (age 7)

For the month of September, the S&P Index of 500 stocks was up 0.6%, year-to-date that index has posted a 10.6% return and for the one year ended that performance has been 17.9%. As mentioned, the last quarter was extraordinary and this index posted an increase of 7.7% during the quarter. The Dow Jones industrial average returned a respectable 2% increase in September and is up 8.8% for the year 2018 and has a one-year performance at September 30th of 20.8%. The NASDAQ Composite lost 0.7% during the month of September; however it is up 17.5% for the year 2018 and is up 25.1% for the one-year period then ended. The NASDAQ Composite showed a 7.4% return during the third quarter of 2018, while the Dow Jones industrial average leapt 9.6% during the quarter.

For those of you who insist on investing in bonds come rain or shine, the Barclays Aggregate Bond Index was down 0.6% for September, down 1.7% for the year 2018 and for the one-year then ended was down 1.4%. As you can see, the trend in bond investing is negative and is likely to stay there. For those of you more interested in long-term performance, rather than just recent performance of bonds, the 15-year return on the Barclays Aggregate Bond Index is 1.8%. If you look at the same time period for the S&P 500 index, it was up 9.7% for the last 15 years. There is absolutely no short-term reason to be investing in bonds and, as illustrated, even the long-term performance of bonds is nothing to write home about.

1. TARIFFS

You may recall that in February 2018 the financial markets sold off drastically with the anticipated fear of the tariffs President Trump was going to place on many countries. The so-called financial experts were screaming that tariffs would throw the U.S. economy into recession, create vast unemployment in America and pure chaos in our economy and that of other countries around the world. But not me. As is often the case when economists speak, they were just wrong.

Let us evaluate where we stand on tariffs eight months after the original proclamation. It did not take long before South Korea agreed to the terms of a new deal with the United States for the very basic reason, they had no choice. To the surprise of many, both Mexico and Canada readily agreed to completely redo the NAFTA agreement and have now agreed to terms more favorable to U.S. imports and exports. There were many who said that Canada would back the U.S. into a corner before agreeing to reduce their import duties on milk and other dairy products. I guess they hit a wall, so to speak, as they readily agreed before the October 1st deadline.

It will only be a matter of months, in my opinion, before Japan agrees, as well as the European Union. It is pretty simple to figure out why agreement will be forthcoming. Do they want to sell their products to the United States or just build them solely for their own respective country? The answer is so crystal clear that no explanation is needed. Both Japan and the European Union will be in full agreement before the end of 2018.

So exactly what happens with China? I guess the more accurate question is who really cares. As mentioned so often in these postings, China needs the U.S. a lot more than the U.S. needs China. There is absolutely no question that this would create disruption of the supply chains and many companies that manufacture in the United States, but while disruption will occur, it will not be damaging. Many companies are moving their manufacturing from China into other parts of Asia, such as, Vietnam, Malaysia, Indonesia and India; however, it will hardly affect corporate earnings. The bigger question that remains to be seen is whether China will continue to resist fair tariffs and risk letting their jobs evaporate to elsewhere. I will discuss China in greater detail later in this posting.

2. THE SKYROCKETING PRICE OF OIL

As I am sure you are aware, the price of oil has gone up fairly dramatically this summer. There are many reasons given, but frankly those reasons do not survive the “smell test.” The most important reason is that on November 2, 2018 the U.S. will sanction oil that is shipped from Iran. These sanctions will be devastating to the Iranian economy since, unlike before, the U.S. will hold any country that imports Iranian oil accountable. In an act of absolute brilliance, the current President has made these sanctions very simple. If you want to trade with the United States, then you will not import oil from Iran. Take it or leave it. You can either trade with us, or you can trade with them, but you will not trade with both. Never before have sanctions so affected the Iranian export of oil. Already European companies are pulling out of Iran manufacturing and Europe has already canceled long-term contracts to buy oil from Iran. No question that China will fight this policy and buy oil from Iran, but the rest of the world buys oil at their own risk.

What is interesting about this concept is (for reasons totally unclear to me) the price of oil has gone up in the United States by 30%. Do you know how much oil we have bought from Iran over the last 10 years? None! So, the price of oil in the United States has nothing whatsoever to do with the sanctions on Iran. I have been watching the oil markets my entire professional career, which spans over 40 years. What is absolutely clear in the oil market is there is total collusion when it comes to pricing. If one oil company increases the price at midnight on Christmas Eve all the others will simultaneously increase it by the same percentage. There is nothing economically justifying the price of oil at the current time other than the price of oil has been too low for too long and it is now time for catchup. You should read nothing economically into the price of oil at the current time.

However, the positive impact of increasing the price of oil is that shale manufacturing will explode. With the price of oil up, exploration can continue and as this happens the shale fields will become increasingly profitable, putting more people to work at high paying American jobs. It is amazing to me that the financial press cannot understand how the sanctions of Iran have absolutely no negative impact on the United States and that the increased price of oil actually helps the U.S. economy rather than hurts it. So, if this is one of your concerns going forward, that concern is misplaced.

Our awards displayed on our front doors

3. INVERTED BOND YIELD

There has literally been tons of ink spilled on the subject of inverted bond yields over the last 12 months. It is true that an inverted bond yield is an early signal that there might be a recession coming into the economy. It has been an indicator that has proven to be correct numerous times over the last few decades. If short-term interest rates exceed long-term interest rates then businesses will not invest since it benefits them to wait until the future, when these rates are lower. This timetable of waiting to invest slows the economy and for all practical purposes leads the country to recession. As you can see, with higher short-term rates than long-term rates, companies are unwilling at the current time to borrow money to invest in their plant equipment since it would be cheaper to wait until the rates fall.

What is rarely reported regarding an inverted bond yield is that there is a long, inconsistent lead time between the time the bond yield inverts and before the economy actually falls into recession. Over time, that lead time has proven to be in excess of two years. So even if you had an inverted bond yield today, which you do not, it would most likely be over a two-year cycle before you actually saw it affecting the financial markets.

So much has been said about the inverted bond yield but there is very little information given to the real numbers. As I have pointed out for years, one of the reasons why the 10-year Treasury is held back is due to the low 10-year Treasury rate in other countries. As an example, the 10-year Treasury in Germany is at 0.576%. In Japan, the 10-year Treasury is at 0.147%. In the United States, the 10-year Treasury is 3.233% as I write this. Therefore, because the rates are significantly higher for our 10-year Treasury rather than the Treasury of these developed countries, money will move to the U.S. to take advantage of the higher rates. That movement hurts the currencies in both Germany and the European Union, and of course Japan. The most important aspect of this occurrence is that all of the money flowing into the United States Treasury market from around the world keeps the interest rate on the U.S. bond rate lower than it actually should be given normal economic circumstances. This is a good thing since it reduces the cost of capital for home building and the purchase of automobiles in America.

There is no question that higher interest rates will impact the economy since virtually any debt maintained on a variable rate will go up, costing consumers more money to service this debt. But as I write this posting, the 10-year Treasury is at 3.233% and by no definition does that denote any type of inverted bond yield. Therefore, if one of your concerns continues to be fixated on the potential inverted bond yield, we are not even close to that at the current time. Even if we had such a yield, it would be years before it affected the financial markets. Rather than focus on the fact that 10-year Treasury rates are going up and the effect that it might have on the future earnings of consumers, it is much more important to focus on the reason why they are going up. 10-year Treasury rates would not be going up if it was not a result of the realization that the American economy is increasing in value. As a general rule, interest rates fall as the economy declines and goes up when the economy improves. This week, the chairman of the Federal Reserve Jerome Powell said, “There’s really no reason to think that this cycle can’t continue for quite some time, effectively indefinitely.”

4. THE STOCK MARKET VALUATION IS TOO HIGH

I wish I had a nickel for every time I heard this statement from so-called experts on the financial news. They keep quoting that the stock market valuation is too high, and therefore they would not invest new money. The first thing you have to realize is that, by historic standards, today’s stock market is different than prior years. With the advent of 401(k) plans back in the 1970s, that vehicle has become the standard for retirement in America today. The actual pension plan, as we know it, virtually does not exist any longer. Americans, from the very young to the very old, invest money in their 401(k) plans on a weekly or monthly basis directly from their paychecks. It is presumed that roughly $2 billion per day flows into American 401(k) plans. This money is not concerned about market valuations since facts indicate that markets go up over time regardless of good or bad economic projections. Therefore, as an anchor on the market, this money continues to flow regardless of projections by so-called experts.

So, is the market overvalued or are those projections just released to promote whatever product they happen to be selling on any given day. The sure way to find out is to look at the earnings of the S&P 500 index as projected for 2019. As of the date of this posting, they are projecting earnings for the S&P 500 for 2019 as $176.52. If you will look at my year-end projection, I forecasted that the S&P 500 would end this year at the 3,000 level. That is up roughly 3% from where we ended the month of September. If you divide 3,000 by 176.52, you get a price-earnings ratio of 17. Do you want to know an interesting fact? The price-earnings ratio for the last 75 years in the stock market has been 17. Therefore, to argue that the stock market is overvalued at the current time clearly indicates an unawareness of the facts.

Then again, I also hear on a daily basis that we are on a “sugar high”. There is no question that the earnings have increased dramatically because of the reduction of income taxes. But the one thing that people cannot seem to grasp is that taxes are not going back up for years to come. Therefore, it is not expected that these earnings would go down in the second year of income tax reductions. In fact, with an extraordinarily strong U.S. economy and growing optimism by consumers, the more likely the trend for 2019 and 2020 is up rather than down. Therefore, if one of your concerns focuses on the already fully priced stock market, you can discard that concern as being inaccurate.

5. THE ECONOMY

I keep hearing so many clients say that we will go into recession shortly given the outstanding performance of the economy so far. There is absolutely no historical precedent for an economy going from 4% to recession in a short time period, short of economic disaster or a worldwide economic event such as war, etc. As mentioned in the title, with unemployment at its best in 49 years, more Americans are working today than ever before in the United States. More people working means more people paying taxes and more people contributing to the economy. We had a 4% GDP in the second quarter of 2018 and the Federal Reserve Bank of Atlanta now forecasts the third quarter GDP at an increase of 4%. There is no economic standard or preamble to the future that would indicate that any recession in the U.S. economy is anywhere in sight.

I do, however, agree with the assessment that in all likelihood the U.S. economy should fall into recession in the second half of 2020. This is based on the Federal Reserve’s desire to keep a level economy and prevent it from overheating. However, at their rate of a quarter of 1% increase in interest rates per meeting, it is not likely to occur for at least two years. So, if your argument is that the U.S. economy is going into recession, I would concur. However, that potential recession is over two years from today, so why anyone would make changes in their portfolio to provide for a recession two years out does not warrant discussion.

To invest in bonds at the current time, as interest rates go up, is not likely to be profitable. I often ask clients why their portfolio is currently invested in bonds. Even after I go through a lengthy explanation of why it is almost a certainty that bonds will produce a negative rate of return, they continue to express their desire to be so invested. In my opinion, this is sort of like stepping in front of a train. You know disaster is coming but you don’t know when. The time to invest in bonds is not during an economic boom like today when interest rates are increasing but rather when the Federal Reserve is trying to stimulate the U.S. economy by decreasing interest rates. That date is likely two years from now.

6. CHINA

Is your concern that China may in fact economically overwhelm the United States, and therefore you do not want to invest in the U.S. stock market because of this fear? There is no question that the Chinese stock market is the cheapest in the world. By any valuation standard, stocks are dirt cheap in China. Would I invest there today? Absolutely not.

Let me give you a quote that I think about often times when the discussion of China occurs. In many eyes, China has performed miracles by converting their economy from basically a very small middle-class to a middle-class population today that exceeds the population of the United States. They have brought people in from the fields and trained them in manufacturing and made these workers the envy of the world in creating products that can be used in the U.S. and other countries. However, they are playing economic roulette with this middle-class. You cannot create a middle-class that wants higher and higher wages without passing on that cost to the consumer. However, China has not done so. In the last 15 years, average export prices to the United States have been unchanged. Basically, think through that statement. For the last 15 years, prices in the U.S. have been stable in U.S. dollar terms. Except, if you consider that in China, the average wages have gone up over six times. How can a country continue to increase the compensation to their employees but yet their pricing remains stable?

Economics would contend that China is a country headed for economic chaos if their costs continue to go up but their prices continue to go down. One way they have been able to accomplish this is by manipulating their currency and by borrowing an excessive amount of debt to finance their economy. Once again, a risky move from an economic standpoint. Even though their economy continues to grow, it is currently declining. As I write this posting, I note that China has actually taken extraordinary measures to increase their performance. This is a direct action to circumvent the tariff costs of their products shipped to the United States.

It is clear that the Chinese government recognizes the perils of reducing their currency and flooding the economy with more money to offset the negative effects of the tariffs to the United States. A much bigger fear should be that due to this increased cost, their supply lines are being replaced by other countries and this business is lost to the United States forever. Over the weekend, China reduced the amount of cash that the banks are required to reserve for future growth, therefore weakening the banking system. They have dramatically decreased the amount of reserves these banks hold, and therefore are pushing the banks to lend more to the economy. In addition, they are flooding the banking system with new cash to the tune of $109 billion in order for banks to have the excess capacity to loan more.

If you assume in China, as in the United States, that $1 creates $7 in GDP, this is flooding the economy with close to $700 billion of fresh money to create GDP. Those of you who remember the 2008 financial disaster, the TARP at its maximum would have only been $700 billion but in fact less than $300 billion was actually injected into the banking system. It is not often reported, but all of the TARP dollars were repaid with the Federal Reserve actually making a profit on the transaction from TARP. Yes, there were defaults on debts, but the debts earned so much for the Federal Reserve that it did more than offset the losses.

There is no question that you will see the Chinese devalue their currency to offset the price of tariffs in order to remain competitive. It is also crystal clear they are concerned about their economy or they would not be injecting so much money into their banking system. Would I invest in China today? No, I would not; they are looking at hard times for as long as they fight the tariffs in the United States. So, I will say like I have said before – China will agree to the tariffs for one very simple reason, they have no choice.

7. EMERGING MARKETS

At the current time, we are moving our emerging market investments, not that I do not expect them to do well over the next year or so, but because their volatility and unknown nature is unnerving to investors. In fact, many of the emerging markets will greatly benefit by the increase in the price of oil. However, at the current time, currencies in these emerging markets are cratering as compared to the U.S. dollar solely for the reason that the U.S. economy is so strong and their economies are so weak. With so many of the emerging markets’ economies dependent upon selling to the United States, as their economies decline and the U.S. dollar goes up, they get a boost in productivity due to the currency exchanges. I fully expect that emerging markets will regain their footing over the next year as earnings go up and their economies stabilize. If I have to invest in one market at the current time, it would be the U.S. We will let the volatility of the international and emerging markets stabilize before moving assets back in that direction.

I have tried above to address all of the issues I think you could raise when deciding whether or not to invest. It is absolutely overwhelming to me how much cash is sitting in investors’ banks accounts earning zero. I get so many reasons why that money is not invested, many of which are itemized above. I am not going to say that I am always right, nor have I been 100% correct over time. However, for the last eight years I have been advising, if not even begging, clients to invest their excess cash as the markets were moving higher. I guess from that perspective, that has been a crystal-clear winning recommendation. But if you continue to resist investing, I would like for you to consider the reasons as itemized above and assume that whatever your argument is for electing not to invest could be answered with a positive response above.

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