May 2018 Client Letter

Adapt, Evolve and Prosper
6/5/2018

One of the constant questions I ask myself is “Where are we in the business cycle? And, how much time does it have left?” Employment and GDP growth look great now and, as humans with a positive attitude, we’re inclined to think the good news will continue indefinitely. But the problem we have at this late stage in the cycle is the Federal Reserve will soon be raising rates to the point where they will be generating a great deal of pain to the economy. As sure as the sun will rise in the morning, the Fed will push the economy into recession.

The rising stock market acts like a slight of the hand trick distracting us with strong momentum and keeping our attention away from the Treasury bond market. The continuing shrinkage between the yields of the 2 and 10 year Treasury bonds are telling us that we are soon to be at the peak of the business cycle. There is no immediate danger right now as risk assets like stocks, commodities, real estate and crypto’s could have another 6 to 9 months to run higher.

For those of you who are new or have never experienced a cycle peak as an investor, I’m not talking about an ordinary garden-variety market pullback but something on the order of 3x to 4x of the January decline. These cycle peaks are not to be ignored as risk assets are frequently crushed.

I realize this sounds ghoulish and fearful but it’s real. To be frank, from the investment point of view, it’s the necessary transition from an old Bull Market to a new Bull that can last for years. The fulcrum point which could tilt the balance from stocks to bonds will be handled with care as my goal is to continue the growth curve of your accounts by adapting to a changing environment.

As I’ve mentioned in previous letters, I may anticipate a major move in an asset class but I want to see price confirm my suspicion before I act in force. Many an investor goes broke trying to predict what may happen; I prefer to wait until price confirms my thesis.

The best investors in the world have the ability to adapt and conform to whatever environment they face. Passive Indexing, Buy and Hold strategies and those not paying attention are reliant on a rising Bull Market for gains. That’s not the case with RMHI. As an active manager on your behalf, I look at recessions as an opportunity and will reconstruct your investment portfolios to prosper in the coming Bear Market.

A business expansion period can last for most of a decade. In contrast, the cycle peak-to- trough is usually about a year. In other words, risk assets fall a heckuva lot faster than they rise.


There hasn’t been much to say recently as the markets chop up and down with modest net progress. Long term trends for stocks remain positive but there are new signs of life in Treasury Bonds. Everyone, including myself, was looking for higher interest rates in January but I believe that moves to higher rates are over and a reversal to lower rates is emerging. The move to lower rates has likely been magnified by Italy but the closing gap between the 2-year Treasury Bond and the 10-year has been an ongoing trend.

Nasdaq Composite Index; Socially Responsible Investing

The Nasdaq Composite Index remains the strongest market index as it contains the highest percentage of the best growth companies. In addition, today (June 1) the Nasdaq is breaking out of its May trading range and could be the first of the major indices to reclaim the January peak. So I’m maintaining a higher than average percentage of client assets in Technology as it remains one of the strongest industries (aside from Oil and Gas which of course we don’t touch).

The focus of this client letter is the price behavior in Treasury Bonds and the impact of the world’s Central Banks shifting their policies from pro-growth to restrictive. They’ll likely be very problematic for the economy and stocks in six months to a year.

As the chart below reveals, the world’s central banks are acting in unison. By 2019, the world central banks will be initiating a global slowdown in growth.

Central Banks Balance Sheet; Socially Responsible Investing

Its quite possible that the reversal in Treasury bond prices is a nascent trend that could bring interest rates much lower which in turn would trigger the infamous “Inverted Yield Curve” (IYC). The IYC is a wonkish term to mean that short term interest rates are higher than long term interest rates. IYCs have an impact on consumers since it forces those with adjustable rate mortgages to pay more than fixed rate. The same holds true with lines of credit.

Treasure Bonds Trend; Socially Responsible Investing

This chart above is a long term chart that does a nice job of revealing the long term trend in long term bonds. The blue line is a 48 month moving average and it conforms to the upward trend. But this month the price of long term Treasury Bonds jumped 2% and is right on the trend line which tells me that all the talk of rising rates is probably wrong.

Plus, given the trends in the Yield Curve which are becoming more ominous, there is a very good chance we’ll begin to buy long term Treasury Bonds in anticipation of a weaker stock market and recession in 2019 and 2020.

It’s a cold truth that every Bull Market will be killed by the Federal Reserve and that includes the Bull Market that exists today, which leads us to this point in time.

Yield Curve Making New Lows

The next chart is a graph of the “Yield Curve”. Its a common occurrence that before recession induced bear markets, the Yield Curve inverts. The Yield Curve has inverted ahead of every recession in the past 40 years. How much money and grief would investors save just by tracking this bit of data?

Yield Curve; Socially Responsible Investing

The Yield Curve is calculated by subtracting the yield of the 2 year Treasury Note from the yield of the 10 year Treasury Bond. Today its 2.83% – 2.40% = .43% as seen in the chart below. Look on the chart above to see how the Yield Curve behaved in 1998-1999 and 2006-2007. By the time the curve turns upward, it’s too late as the damage will be done and the Fed will try to reverse course.

Yield Curve; Socially Responsible Investing

US Monetary Policy is the primary reason we have Bull Markets and Bear Markets for almost every asset class. As the chart above reveals an inverted yield curve has been an excellent forecaster of incoming recessions.

There is a lag time of 6 to 24 months between inversion and recession and we can’t be fooled into thinking “this time it’s different” that a recession won’t occur.

The yield on the 2-year Treasury Note is based on the Federal Funds rate which is controlled by the Federal Reserve. See chart below. The Fed is stair stepping rates higher and has plans to raise rates by .25% two more times this year. Assuming the 10-year Treasury Bond yield stays put, those rate hikes could cut the margin by .50 and down to -.05% (Yield Curve Inversion).

Fed Funds Stair Step; Socially Responsible Investing

When the yield on the 10-year Treasury and the 2-year T-note are equal or inverted it becomes a giant alarm to run and not walk to the stock market exit. During this period we will sharply reduce are stock holdings to pare down risk. In the past 3 months we’ve head a series of declines in the S&P 500 Index which stopped right on the 200-day moving average (DMA). In a Bull Market we may hedge against the index falling below the 200 DMA but the odds are not very good for major break below.

When monetary policy (meaning the Fed hiking rates) becomes very aggressive, as might be the case in 2019, I would expect a decline back to the 200 DMA followed eventually by a major break below the average and an additional decline of 25% to 40%. This sharp break below the 200 DMA is the trigger point for me to increase exposure to Bear Market related strategies and keep our stock holdings to a minimum.

This next chart below, produced by the St. Louis Federal Reserve, is their own projection of where the Fed Funds rate might be in 2019. They’re projecting the Fed Funds to be a 3.4% late in the year which is well above the current yield of the 10 year Treasury bond of 2.83%.

Fed Funds Projection; Socially Responsible Investing

On the bright side, and there is a bright side at least for the time being: Employment.

Historically, unemployment claims start to rise at least 7 months before a recession and there’s no sign of that now as the chart below illustrates.

Unemployment Claims; Socially Responsible Investing

Summary: The present data is supportive of a continued market rally in equities and of economic expansion. But looking six months ahead there is concern that we could be dealing with a stock market and business cycle peak. We’ll be prepared to shift from Bull Market positioning to Bear Market strategies in all portfolios. The primary trigger will be a decisive move below the S&P 500 200-day moving average. In the meantime, enjoy the summer and the next leg of the rally.

Thank you,

Brad Pappas

Disclaimer; Socially Responsible Investing

Investors may hate taxes but they hate losses more

Recently I’ve seen a few studies and charts on Twitter that lend favor to Tax Efficient Investing. These are portfolios where each holding is designed to be held for more than one year. This stragegy allows them to qualify for reduced taxes as a Long Term Capital Gain. The articles I’ve seen generally advocated by financial planners and advisors who see Tax Efficient Investing as their way to add value or have an edge for the clients of their practice. But not once have I seen a credible article playing the role of Devil’s Advocate for Tax Efficient Portfolios. Today the Dow Jones Index was down 660 points at mid-day. It would seem apropos to highlight a few of the disadvantages of Tax Efficient Investing.

The points I will make are from the perspective of a Growth-oriented investment advisor whose primary investment vehicles are stocks, ETF’s and ETN’s. Municipal bonds are a different animal altogether and not the subject of this blog post.

Are the lower taxes worth the losses?

The primary objective of Tax Efficient Investing is to own an investment for at least 12 months. Our primary objection to this strategy is prioritizing time of ownership over gains. Investment gains can disappear or be significantly reduced by the goal of hanging on for one year. For example, you buy a stock at $50 on January 1, 2017 and perhaps by April 2017 the stock is $65. But by January 2, 2018 the stock could be anywhere. A major sin of investing that you open yourself up to is not taking the gain in April. If the market goes into a sell-off where the stock goes back to $50 or below, your gain has been negated. It reminds me a bit of the game show “Let’s Make A Deal” with Monty Hall. Monty would offer a contestant a sure deal right off the bat, but with the caveat of “Would you be willing to give up the sure deal for whats behind Door 1”. It could be a brand new living room or dinette set (hey I watched it in the 1970’s). It could also be a rusting bucket of used auto parts. At that point Monty would offer the bizarrely dressed contestant the consolation prize of the home version of the game show. Cue sad trombone.

The stock could also have gone to $75 in good market as well, up 50%. If the stock continues to rise without any major setbacks, an experienced Trend Following methodology as well as a Tax Efficient investor would likely continue holding on to the stock. There is a primary difference between a Trend Following system – which we employ – versus a Tax Efficient strategy. We’d take a profit should the stock decline below important benchmarks. Declines below certain sell points raise the question of whether the stock is even in an uptrend. By the way, how hard it is to find a stock that can smoothly rise throughout the entire year? This means the company must produce 4 good earnings reports in a row and not sustain large pullback. 2017 was an easy year for Trend Followers. Even then almost 95% of the stocks we bought could not sustain 12 months of positive performance.

Are the drawdowns tolerable?

In point 1 I discuss a scenario of a single stock. But if Tax Efficiency is the goal along with long term Growth, you can now envision how volatile that portfolio would become. By not exerting proper risk controls, the portfolio would likely have longer and more significant drawdowns. Is that something you really want? Most investors, especially those who are new to investing cannot endure declines of 30% or more to their portfolios. This begs to ask:  “Would you pay a bit more in taxes for less volatility?” In my experience which is based on client retention, the answer is “yes”.  People hate losing money more than paying higher taxes.

What about lagging holdings?

Digging down deeper into portfolio management is the issue of what to do with lagging holdings. A lagging holding is the stock that you have had a gain on, but is now going nowhere. Our view is to sell laggards in a rising market. We don’t see the value of holding an investment unless its producing for you. A major advantage to this is to look for new potential winners. But the Tax Efficient portfolio may hang on to the stock till it clears the one-year hurdle. This is another factor contributing to underperforming portfolios.

To sum it up: Tax Efficient Investing can be a proper strategy for some investors but for most it isn’t. Investment methods must not just make financial sense. The methods must also be cognizant of the investor’s risk profile and emotional impact. One size does not fit all and every investment method has some inherent weaknesses. Most investors would probably feel more comfortable knowing the achilles heel of any strategy.

Cheers,
Brad Pappas

 

December 2017 Client Letter

Euphoria in the air
12/15/17

Quick Summary: So much for the consensus opinion of being in a “low return environment”. November was a terrific month that brought back some memories of 1999 when Tech stocks rocked higher every day. In my opinion there was a bit of euphoria in the air as so many of our stocks either went parabolic or increased their angle of ascent above 45 degrees.

There is the potential that we will see a shift in stock sectors in 2018 from Growth to Value but it’s really too early to tell. Since mid-November it seems all the sectors and groups that lagged this year are playing catch up while the winners move sideways.

Odds of a recession starting in 2018 are very low and most data points to healthy growth once again for the coming year. The Fed will be stepping up their rate hikes in 2018 which is giving traction to Treasury bonds and I’m focused to see if any rise in the price of Treasuries accelerates. If that’s the case then Treasuries will be essential in 2018.

As I can tell there are two points of concern coming into 2018: Investment sentiment is too high. This sets the stage for a reversal and correction at some point next year. The bull market will be another year older which increases the chance for pullback in 2018. The Bitcoin craze is an example nutty hysteria as there are now stories of people mortgaging their homes to buy more crypto currencies.

The second concern is the status of the North Korean issue. Markets have been very calm in the face of the tension as the largest institutional investors believe some deal or Treaty will eventually evolve.

Growth versus Value
Growth Stocks have had a great year relative to Value stocks in the last year. But recently Growth has broken its upside trend line as it declined sharply relative to Value. Markets never make it easy for anyone and those who think just owning Amazon, Facebook and Google constitutes a good “buy once and forget” may find their portfolio adrift going nowhere next year.
Growth performance exceeding Value performance - Socially Responsible Investing

Tech stocks have not given up their leadership completely just yet but I’ve moved to a more balanced industry portfolio spread across more industries this month.

Our biggest winner of the year was symbol “BABA” Alibaba Group Holdings which we bought in January and sold recently. The chart shows how BABA shares have made little progress since August despite a very strong Nasdaq. The stock is showing signs of distribution as large investors started selling in early November. Recently it broke through its 50 day moving average. Investors seem reluctant to defend the stock on any selling so we took our profit.

BABA was our biggest winner for the year - Socially Responsible Investing
I do have a rule regarding investments that move higher to a parabolic degree. Parabolic moves are unstable and prone to sharp reversals. This was the case with Square which was another good winner this year. But the stock turned on its booster and went parabolic in early November and we sold in the $46-$48.

SQUARE went parabolic - Socially Responsible Investing
One of our losing positions in November was Micron Technology which we bought in the $48 range and sold at $40. While it has since rebounded a bit I’m still very suspicious about the near term of Semiconductor stocks as they’ve had a great run.

MU lost - Socially Responsible Investing
Nothing since the crazy Dutch Tulip Bulb craze have we seen anything like Bitcoin. If Bitcoin does collapse from its parabolic hysteria the losses could be epic. I must be the only person who has ever been stopped out of GBTC but the problem is that Bitcoin trades 24 hours a day. This means that stop loss orders on the Nasdaq for GBTC could be almost worthless in keeping losses small. We could have a stop loss order to keep a loss at 5% on the Nasdaq but since Bitcoin trades 24 hours a day the opening price for GBTC could many multiples of 5% up or down. With undefined risk I won’t trade it.

That’s it for now. I wish you all the best of the holidays and a prosperous 2018.

Brad Pappas Brad@greeninvestment.com

email disclaimer - Rocky Mountain Humane Investing - Socially Responsible Investing