What We’re Thinking

OBSERVATIONS ON NOVEMBER 2018 STOCK and BOND MARKETS

Two front page headlines from the NY Times, nine days apart, tell a good deal about November volatility, both up and down, for the US stock markets: On November 19th (NYT, 11/19/18, page A1), “Tech Stocks Dive as Wall Street Loses Gains for Month,” and then November 28th (NYT, 11/28/18, page A1), “Markets Soar on Two Words From Fed Chairman.” By the time November ended, the three major US indexes all showed modest month and YTD gains (see page 1).

NOTE:  The closing value of the S&P 500 on November 19th (as reported in the 11/19/18 article), was 2,691, and the closing value on November 28th (as reported in 11/28/18 article), was 2,744, a 2% difference. The range of high and low for the month was 2,632 (November 23rd close), to 2,814 (November 7th close), a 7% difference measured from the low. By way of comparison, 2018 has had four other months of similar or higher volatility.

We will spare you the repetition of the media’s discussions of the day to day reasons for all this volatility, and instead acknowledge that the current financial markets are likely being driven more by current events than by fundamental economics. That said, there is still no reason to change your previously established asset allocations to and away from stocks, even with all this volatility. Long term investors learn to ignore the not uncommon, and noticeable, fluctuations in stock prices.

Turning to bond prices, they were modestly higher in November, as interest rates on the ten-year US Treasury declined from 3.16% to 3.0%. This was surprising, because higher interest rates have been presented as one of the main reasons for the recent stock market declines (even though they had been increasing for much of this year, while stock prices moved higher until the end of September). The above mentioned November 28^th article provides a rationale for this situation: the Fed may be close to ending its program of increasing interest rates in the future, which presumably benefits stock prices. But, as we always point out, stock prices are impacted by many more factors than just interest rates, whereas bonds are impacted almost most entirely by interest rates.

EARLY DECEMBER UPDATE

When preparing our Monthly Comments, it is our practice to limit the discussion to the month about which we are writing.  That said, we want you to know we are keenly aware of the early December market volatility, and stand ready to write additional one page Special Comments as warranted. We note that as of the close of December 6th, after an extremely volatile day ending with a small change, the S&P 500 index is still slightly above its year end 2017 level, and its recent February and October 2018 lows.

PPA BOOK CORNER: FACTFULNESS

We recently read a book we found very interesting, with some relevance to the financial issues we work on with you. It’s called Factfulness, by Swedish physician Hans Rosling, and we encourage you to take a look if you have some time.

In the face of much bad news in the world today (financial and otherwise), Rosling seeks to provide fact-based information to counter ten “instincts”, or barriers, that he claims prevent people from acknowledging many slow, steady improvements. He uses UN data to show, for example, that extreme poverty is declining and life expectancy is increasing in almost all countries. And he offers useful advice to help us understand that while certain situations continue to be bad, they are getting better.

Chief among these barriers is the “gap instinct”, or the propensity to see the world in binary terms – us vs. them, “the west and the rest”, developed vs developing countries—when the reality is much more complicated. Rosling presents a fascinating graphic on the inside front cover of the book that plots incomes and lifespan (his surrogates for overall wealth and health) for all 195 countries across the globe. Instead of dividing the world in two, he frames almost every discussion in the book around an analysis of four basic income levels, and focuses on how almost all countries have moved up and to the right on this chart (i.e., to more wealth and better health) over the past two centuries. (See YouTube also for a fascinating video called 200 countries, 200 years, 4 minutes, which illustrates the fluidity of this phenomenon.

The next major barrier is the “negativity instinct”, which involves an often vicious cycle of media reporting bad news – war, violence, scandal—and people thinking that’s the only news out there. Rosling again urges readers to look beyond the scary headlines to data showing improvements in many areas. He presents charts of 16 “bad things decreasing”, including many diseases, hunger, deaths from disasters, and environmental toxins, and 16 “good things increasing”, including girls in school, literacy and immunization rates, “protected” nature and clean water (pages 60-63). Rosling doesn’t want to be seen as a Pollyanna, but neither does he assume the cynical tone of the eternal pessimist. Instead, he considers himself a “possibilist”, acknowledging that while much work needs to be done, much can, and already has been, improved.

The third significant barrier is the “straight lines instinct”, in which people assume that troubling trends will continue at the same rate, instead of leveling off or even declining due to changes that reflect broader improvements. Rosling’s main example here is population increases, which have rocketed upward in the past 100 years. But according to UN forecasts, these increases are expected to grow less quickly over the next 100 years, due to declining birth rates that in turn stem from less poverty, better education, and more access to contraception in lower income countries (pages 80-86). More generally, instead of projecting from just two data points, Rosling encourages the search for additional data that might reveal the real long-term trend.

Rosling also addresses a number of relevant financial issues in the context of other barriers. Related to the “fear instinct”, he criticizes the media (page 104) for its often short-term thinking and scare tactics, a view PPA shares often in our monthly commentaries. Rosling provides a useful distinction between perceived risk (or fear) and real risk, which he calculates as danger multiplied by exposure (page 123). This is a helpful way to think about balancing risk and return in your portfolios, specifically by raising or lowering your allocation to stocks (i.e., adjusting your exposure to the “dangerous”, or most volatile, part of the markets). In his discussion about the “urgency instinct”, Rosling explains how we tend to focus on present risks (e.g., daily or monthly ups and, especially, downs in the markets) as opposed to future risks, such as not saving enough for retirement (page 228). He also encourages going beyond a single estimate (page 231), and instead testing at least three scenarios when making projections (e.g., expected, better, and worse), which PPA typically does with your retirement illustrations. And in terms of specific thoughts on investing, Rosling discusses the “destiny instinct” in encouraging investors not to dismiss opportunities in poor but growing parts of Africa, Asia, and South America (page 167). This might lead to an additional allocation to “emerging market” or even “frontier market” stock funds for the international stock part of your overall portfolio.

Sadly, Rosling died in 2017 (his son and daughter-in-law finished the book and continue his work). But his writing inspires an infectious enthusiasm for his wide-ranging interests, and we greatly appreciate his concluding plea for humility and curiosity: be humble in the context of a growing, uncertain world, and remain curious about other people, ideas, and possibilities for improvement.

During October, US and international stock prices fell sharply, although US stocks continued to outperform international for the year. These Comments will discuss mostly US stocks (we discussed international stocks last month).

Using the S&P 500 as a proxy for US stocks, the chart below shows results since Trump’s election in early November 2016, through the end of October 2018. (This chart also appeared in our recent October 24th special memo.)

These figures tell us that even after accounting for serious declines in February and October 2018, US stock prices are approximately 2% higher than year-end 2017, and a very substantial 25% higher since November 2016. Even with all the problems that the media is quick to highlight on down days, US stock prices have gained 25% in the past two years. For much of that time, the markets have known about and been dealing with most of these problems.

The more significant issues regularly cited in the media include “President Trump’s trade war with China; the Federal Reserve’s stated plans to keep raising interest rates; signs that labor and other costs could climb; slowing growth in Europe and China; and the tax cuts that increased growth in profits this year will not have the same year over year effect in 2019” (NYT, 10/31/18, page B1).

What follows are Park Piedmont’s (PPA) observations about these issues. The overriding question here is: why did dramatic stock price declines occur in October, after reaching new highs over the summer, since so much of this news has been known for many months?

1. Higher Interest Rates: The US Federal Reserve has raised the short-term rates it controls by 25 basis points (bps) three times this year. In 2017, there were also three increases of 25 bps. As the chart on page 1 indicates, ten-year US Treasuries yielded 2.45% at the end of 2016. Through 2017 and 2018 year to date, there have been six quarter-point increases. The ten-year Treasury could yield 3.95% to cover all six increases, but it currently yields 3.15%, well below that rate.  Taking a two-year view of interest rates, we see they haven’t risen as quickly as they could have.  This is barely discussed in the popular media.

   The Fed raises rates when it believes the economy is growing too quickly, with the objective of heading off inflation before it takes hold. But most people like a growing economy, which supports more employment, more wage growth, more consumer spending, more home purchases, more business investment, and more business profits. Fed rate increases are therefore not too popular.  But at some point, the rate increases take hold and the economy does slow down. That in turn reduces employment, along with the rate of rising wages, consumer spending, home construction, and business investment and corporate profits, which in turn has an adverse impact on stock prices.  If the stock market was predicting all this in last month’s price declines, the question is why did it take until October?

   Another consequence of higher interest rates is that they make investments in bonds more attractive, because investors receive the benefits of the higher rates as existing bonds mature.  When bonds become more attractive, there is some reallocation of investor money away from stocks.

   Higher interest rates also create a stronger US dollar, which has adversely affected a number of emerging market countries that borrowed money in dollar-denominated loans, and now have to find a way to pay the loans back with more expensive dollars.

2. Tariffs and “Trade War” with China: The Trump administration has decided that it is in America’s interests to reduce the trade deficit with China, and to get China to stop stealing technology secrets. To further these policies, the US has imposed tariffs on many goods coming from China, which effectively raises the price of those goods, reduces demand, and, presumably, overall economic activity. China has reacted with its own tariffs on US goods, but is apparently more adversely affected than the US, because its stock market has been down as much as 20% during 2018. This issue has been going on for months, and the media constantly references it as a reason for down days. But how then to account for the up days, and a 10% market gain in the US through the end of September 2018.
3. Increasing Budget Deficits: The Trump administration has also been successful in pressing Congress to pass large tax cuts that primarily benefit large businesses in an effort to stimulate growth in the US economy. With lower tax collections, the US budget deficit has increased substantially, which means more borrowing is necessary by the US government. The proponents of tax cuts take the position that the economic growth will eventually add to the taxes collected, by virtue of more and higher wages for individuals, and more profits for corporations. There are many sides to this question, but why would this be a reason for October’s declines, since it too has been known for many months?
4. Higher Wages Potentially Reducing Corporate Profits: This may be, but these same higher wages create more demand for businesses, and the opportunity to earn more profits. And the same question about why this factor should have been discovered in October remains.
5. Other Political Issues: It is very difficult to factor these in as causation for October’s declines, as they have been ongoing since Trump took office. And as our chart on page 2 indicates, US stocks are up 25% in the two years since Trump’s election.

As we have consistently maintained in many of these Comments, causation is difficult to attribute and even more difficult to prove, with so many factors affecting stock prices. Comforting as it might be to offer explanations for difficult times like October, we at PPA have no answers as to the day-to-day (or even month-to-month) swings, particularly since the next day the markets are just as likely to reverse course as to continue in the direction they were going.

In other words, volatility is a two-way street; note that on October 29^th, the S&P 500 had an intraday range from high to low of 100 points (almost 4%), which corresponded to a 900-point range on the Dow Industrials (also almost 4%). When this volatility strikes the markets, we re-emphasize our advice to think as long-term investors, with a time horizon of years. If you do need money from your portfolio, it is highly likely to be available from the sale of bond funds, which we recommend as part of most client allocations as a buffer against the inevitable times when extreme volatility affects the stock market.

As stock prices continue their sharp October declines, we are writing to follow up on our October 10-11, 2018 Special Memo, which also discussed these declines. This memo uses the S&P 500 as a proxy for the US stock market, which closed today, October 24, at 2,656. We highlight a few price points for that index since Donald Trump’s surprise 2016 election.

These figures indicate that even with the October declines so far, the index remains substantially positive for the almost two years since the election; still higher than the February 2018 lows; and less than one percent below year-end 2017. Note also that interest rates (ten-year US Treasuries), an oft-cited reason for these declines, are actually lower now than when the serious declines started on October.

Some other observations, expressed regularly in our Monthly Comments:

• There are no guarantees stocks will consistently move higher. Instead, history tells us there can be periods of significant decline, for all sorts of reasons, and the real questions are how long the time period, and the amounts of the declines. History also suggests stocks provide better long-term results when compared to other liquid investments
• Trying to time when to be in and out of stocks cannot be done consistently over time.
• Allocations to bonds and cash equivalents provides a defense against stock price volatility. For example: A 50% allocation to stocks means whatever the percentage decline, your portfolio should be down only half that amount.

Please feel free to contact your us for additional conversation.

As is our practice when US stock prices experience significant declines, we write to comment on what we think is happening. The declines of October 10th were as follows:

S&P 500, down 95 or 3.3%; Dow Jones, down 832 or 3.1%; NASDAQ, down 316 or 4.1%.

We suggest putting the declines in the context of recent gains, in this case measured from 2018 highs and year-to-date (YTD) 2018 gains:

Much of the media commentary on the reasons for the declines centers on rising interest rates, but October 10th actually saw a small decline in the ten-year US Treasury benchmark. This makes us wonder why this particular day saw such a sharp stock selloff. That said, there has been a significant rise in the benchmark rate since year-end 2017, from 2.4% to the current 3.2%. During most of this period, stock prices have in fact been rising.

Further, stock returns so far this year continue to be better than bond returns, which are modestly negative because of the rising rates. However, bonds have a self-correcting mechanism when rates rise, as the additional interest earnings substantially offset the price declines over time.  The issue with stocks is that they have no such mechanism; stocks can suffer serious short-term declines that might not recover any time soon, and can therefore create doubt and unease in the plans of otherwise long-term investors. Which brings us to our constant refrain: Your asset allocation, i.e., the percentage mix of stocks and bonds, is the main defense against the unpredictability of stock price volatility.

Our advice, as usual, is to stay the course with your established allocation, designed to allow you to withstand unsettling short-term price declines.

While US stock prices have continued to rise, international and emerging stock markets have had a difficult year.  These markets are used by investors to provide global diversification for their portfolios. The results for the last few years, and 2018 year to date are as follows:

Some key characteristics of these market sectors are as follows:

Developed International (represented by Vanguard Developed Markets Index fund, VTMGX):

Regions: Europe 54%, Pacific 37%, North America 8%

Countries: Japan 22%, United Kingdom 14%, Canada 8%, Germany 8%, France 8%; Top 5 = 60%; Top 10 = 83%;

Companies: Nestle 1.3%, Samsung 0.9%, Novartis 0.9%, HSBC 0.9%, Roche 0.9%; Top 5 = 4.9%; Top 10 = 8.6%;

Sectors: Fincl. 19%, Industrial 16%, Cons. Discretionary 12%, Cons. Staples 10%, Healthcare 10%; Top 5 = 67%

Price/Earnings (PE) Ratio: 14; 3,900 stocks tracked

Emerging Markets (represented by Vanguard Emerging Markets Stock Index Fund, VEMAX)

Countries: China 35%, Taiwan 15%,  India 12%, South Africa 7%, Brazil 6%; Top 5 = 75%; Top 10 = 85;%

Companies: Tencent 5%, Alibaba 3.5%, Naspers 2%, Taiwan Semi. 2%, China Constr. 1.5%; Top 5 =13%

Sectors: Fincl. 22%, Technology 22%, Cons. Cyclical 12%, Basic Materials 8%, Energy 7%; Top 5 = 71%

Price/Earnings (PE) Ratio: 13; 4,500 stocks tracked

A number of recent articles discuss this situation.

The Economist Magazine (9/13/18) writes that “Emerging markets are suffering their worst slump since 2015. The MSCI Emerging Markets Index entered a bear market in early September after dropping 20 percent from its early 2018 peak.” The article mentions countries as diverse as Argentina, Turkey, India, and Indonesia, all having trouble supporting their currencies (note three of the four countries constitute less than 3% of the index). The article continues “while each country has its own challenges…the US Federal Reserve has played a key if unintentional role in triggering the stress…. With the American economy enjoying a strong upswing, the Fed has been raising interest rates (note, most recent rate increase on September 26), and also unwinding its bond buying policy….The Fed’s policy turn has left emerging nation borrowers scrambling to get more costly dollars to service their debt.” The remainder of the article presents various opinions on how much more serious these problems are likely to get going forward.

A second Economist article (9/22/18, page 65) discussed various countries, including China. The article begins by citing the falling currencies in India and Indonesia, and then states that “even where Asia’s currencies have remained steady, its stock markets have faltered, citing a 20% decline in Hong Kong’s index and a struggling stock market in Mainland China….The trade war with the US has soured the mood in China and Hong Kong….India and Indonesia report respectable economic growth…  and are largely insulated from the trade war thanks to their domestic demand, but are exposed to two other dangers, higher oil prices and America’s remorseless money tightening.”

The NY Times reported on this situation as follows (9/11/18, page B1): “Cratering currencies, rising inflation, jumpy investors: A financial panic is again gripping some of the world’s developing economies. The sharp selloff of emerging market currencies, stocks and bonds seems to stand in stark contrast to the US, where a nearly decade long bull market continues amid buoyant economic conditions. Higher interest rates in the US, and a stronger dollar, rebalance the risks and rewards for investors the world over and act as a kind of financial magnet, pulling them out of riskier investments. While we’ve seen this before….investors had to contend with spillover of trouble from one country to others, dragging down economic growth or causing market stress. So far in 2018 this kind of contagion has been limited. Economies as varied as Argentina, Russia, South Africa and Turkey are facing the maelstrom, but each has its own reasons for falling out of favor, and the turmoil has yet to raise anxiety about the world’s biggest economies and markets.”  The article then discussed the situation in each of the four countries and concludes that “Perhaps most important is a country’s credibility with financial markets. If investors believe a country will continue to pay its bondholders in a currency that retains its value, they will most likely put up with even the ugliest looking levels of debt. If that trust starts to fray, look out below.”

Another NY Times article (9/13/18, page B7) discussed the Developed Markets in Europe. Citing the negative impact of US tariffs, the article states that “the European Central Bank (ECB) has lowered its projections for economic growth across the 19 nation euro area, and warned that any potential escalation of the dispute could create further headaches.” The article also notes trade risks associated with emerging market problems, particularly in Turkey, along with issues related to striking a deal with Britain regarding “Brexit.”  The conclusion of the article however states that the ECB will continue with its plans to cut back on the stimulus programs that were put in place after 2008, in much the same way that the US has cut back these programs, albeit the US economy is much stronger than the EU at this time. The EU outlook currently appears to be much more mixed than that of Emerging Markets, which are wrestling with debt, interest rate, and growth issues.

Despite the current underperformance of Developed International and Emerging Market stocks, we at Park Piedmont continue to advocate some exposure to these sectors as part of a broadly diversified portfolio, particularly since their PE ratios are in the mid-teens, compared to much higher US stock PE ratios, which have climbed to the mid-20s. When PE ratios show this much divergence, it can be argued that the lower PE sector represents a comparative value when compared to the higher PE stocks. As always, only time will tell if this proves correct.

US stock prices have continued to rise, reaching historic new highs last attained in late January 2018, while bond prices have stabilized, resulting in positive returns. These currently favorable financial market results have occurred in the context of the following presumed negatives:

1. New tariffs (see July Comments) on China and other parts of the world;
2. Expectations that the Federal Reserve will continue raising short-term interest rates;
3. Problems in various countries, ranging from China, to Turkey and Greece, to Britain’s “Brexit” outcome;
4. President Trump’s new and ongoing legal and political problems;
5. Historically high Price Earnings Ratio (25, using trailing 12 month earnings; see article on the ongoing US bull market in stocks in The Economist, 8/25/18 print, page 62).

It is fair to ask how this combination of favorable current results in the US is taking place, even with all the negatives. As our regular readers know, we are highly skeptical of attempts to explain short-term movements in financial markets, but we think the current situation calls for some effort to explain.

While not answering the question directly, Jeff Sommer’s NY Times article (9/1/18, page BU3) sheds some light on the positives that might be supporting these market moves:

“While the stock market has been hot lately, warnings of trouble ahead have been multiplying….But what if the good times that are evident in important sectors of the markets and the economy just keep rolling, at least for a while? That bullish possibility has arguably been underplayed, given the strength of the current numbers… Consumer confidence has soared to levels unseen since October 2000, and the US economy’s annual growth rate, 4.2% in the second quarter, was the best in nearly four years, while the unemployment rate (3.9%) hovers near its lowest level in decades. That statistical snapshot depicts a stock market and an economy that are prospering.”

So perhaps this solid economic growth is one reason supporting the current favorable financial market results. Sommers’ article continues to discuss potential pitfalls to the favorable scenario, and also the political implications of the current apparently favorable economy. The article concludes with a quote from a well-known independent stock market analyst, Edward Yardeni, who describes himself as a “conservative-leaning fellow”: “On contentious issues, from tax cuts to trade disputes to deregulation, financial markets have been giving quite a bit of weight to the possibility that this will all lead to less protectionism and greater global prosperity.”

Two other articles appearing in the NY Times (9/8/18, Business Section), make different points regarding the strong US stock market. The more cautious view comes from another Jeff Sommer article (NYT 9/8/18, page BU4), which states that “there has been a disconnection between stock markets and economies around the world, with stock markets generally outperforming their economies…but the US stands out.  There’s a much greater degree of [stock] outperformance and disconnection from domestic economic growth.” The article observes that the US GDP grew 38% (unadjusted for inflation) from Dec 2007 through August 2018, while the S&P 500 index has nearly doubled, but “that does not mean the American stock market will necessarily fall soon. It is being supported by several macroeconomic factors, aside from cash inflows from foreigners. Corporate profits, supported in part by tax cuts, and relaxed regulations and low interest rates, have been rising more rapidly than GDP, while wage growth has been constrained.”

Our note: rising corporate earnings tend to support higher stock prices by essentially lowering the historically high Price Earnings (P/E) ratio closer to its long term average of approximately 15. On the website “Seeking Alpha,” projected S&P 500 earnings to year-end 2018 are $145, which would mean a P/E of 20 using the current S&P value of 2,900. The next twelve months showed a projection for earnings increasing to $155, suggesting further earnings support for current S&P levels. Of course, relying on projected earnings is a dangerous proposition, but is done regularly by Wall Street analysts and prognosticators.

The second article, written by Neil Irwin (NYT 9/8/18, page BU5), discusses the favorable possibility that the US economy may increase its productivity, “allowing for faster output growth and lower unemployment without serious inflation risks,” drawing a parallel to the mid-1990s, when a similar set of positive conditions converged.

Given all the countervailing factors impacting the financial markets, we stick by our usual advice to maintain your asset allocations, and consider re-balancing if one part of your allocation gets too high.

In a recent front page article on tariffs (6/20/18), the NY Times wrote in its lead paragraph,  “President Trump’s threat to impose tariffs on almost every Chinese product that comes into the US intensified the possibility of a damaging trade war, sending stock prices tumbling yesterday and drawing a rebuke from retailers, tech companies and manufacturers.”  For the record, the S&P 500 index closed June 19^th at 2,762, down from 2,773 (less than half of one percent for the day), and closed Friday, August 3^rd at 2,840, up almost 3% from its June 19^th close.

As regular readers of these Comments know, Park Piedmont is almost always skeptical of the media’s efforts to overstate market moves, and to attribute single causes to market changes driven by many factors. Nevertheless, it is worth having a basic understanding of tariffs, some of their effects on economies, and their potential impacts on financial markets.

Tariffs are a tax, mostly on goods, that are imported from another country. If the US puts a 25% tariff on steel coming into the US from China, it is making that steel more expensive. The expected impact is to raise the price of imported steel in the US, thereby reducing American demand for this steel and making steel manufactured in the US more competitively priced. At first blush, it is clear that the US manufacturer of steel is benefitted, and the Chinese manufacturer is hurt.  But it should also be clear that the higher price for steel should likely increase prices for US goods made with that steel, so some other business/businesses in the supply chain, and/or the end consumer in the US, is likely to pay more for the goods made from steel.

In a recent article on tariffs (NY Times, 6/16/18, page A8), Neil Irwin provided his insights on the current tariff situation, focusing on the US-China trade relationship. “The US moved forward Friday with a 25% tariff on $50 billion of Chinese imports, adding to tariffs imposed in previous weeks…. For many years, American companies have complained of being treated shabbily as they try to do business in China. They often must partner with Chinese companies to be allowed to do business in the country, and frequently complain that their most advanced technologies are being stolen, among other concerns. The Trump administration’s list of goods to be subjected to the tariffs is aimed at these high tech sectors…. In return, China said it will place tariffs on $50 billion worth of American imports.”

Irwin continues: “China views the development of its high-tech industries as core to its economic strategy of the future and won’t want to give up advantages in these sectors lightly. On the other hand, the substantial US trade deficit with China means America has more potential Chinese imports on which to slap punitive tariffs.” Irwin then explains that the US and China almost had an agreement on China buying more agriculture and energy products from the US, which would have reduced the trade deficit, but not helped with the longer term issues around technology.

Irwin’s article then turns to the current impact on the US economy by noting that “the US has a gross domestic product (GDP) of nearly $20 trillion, so a new tax on $50 billion (or eventually $150 billion or more) of Chinese imports is a rounding error…. As countries retaliate (with their own tariffs) they can certainly cause damage for individual American industries that export, but the reality is most economic activity in the US is for domestic consumption. Exports constitute about 12% of GDP.” Soybeans, a product heavily exported to China, is cited as an industry adversely affected, along with “some major industries that use steel and aluminum heavily [and] are complaining of sharply higher prices, which make them less competitive against global competitors.”

The article continues: “the risk comes if things spiral out of control in ways that crater the stock market or lead businesses to pull back significantly on their investment spending…. The initial tariffs on Chinese goods are not focused on consumer products, but on products mainly purchased by businesses … which could put upward pressure on inflation…. Even if the dispute spreads to consumer goods, the actual amount American consumers will pay depends on many factors, including the availability of domestic substitutes and the competitiveness of the industry. For any given product it is hard to predict how much of the tariff will be passed through to the consumer versus absorbed by producers and retailers.”

Other articles on tariffs discuss the impact on supply chains. An example from Bloomberg Businessweek (4/16/18, page 11): “It is well understood that tariffs on imported goods raise prices for domestic businesses and consumers…. What is less familiar is that tariffs are blunt instruments that strike every nation in a supply chain, not just the ones being targeted…. Globalization almost guarantees casualties from friendly fire. The US tariffs on steel and aluminum will have impacts on eight or nine mostly developing countries from which China buys iron ore for its steel production.”  Many other examples of the impact on countries in the supply chain of the products being subject to the tariffs are presented.

At Park Piedmont, we view the tariff issue as one of many factors that affect the economy and the financial markets, with highly uncertain impacts going forward. As always, we suggest maintaining previously established appropriate allocations of liquid investment portfolios, even when the media attempts to isolate particular issues as major negatives.

During the month of June, it was announced that General Electric’s stock would be dropped from the Dow Jones Industrial Average (DJIA) of 30 large company stocks. For those of us who remember GE as the largest company by market value in the stock market, this was shocking news.  The stock that people had been told never to sell had fallen so far in value that it no longer warranted being included in the DJIA. But what is the real significance of this event in 2018?

To answer this question, we thought it would be helpful to review the subject of investment indexes, since Park Piedmont Advisors (PPA) uses index funds for most of our client portfolio investments.

The stock market has many indexes that can be invested in using exchange traded funds (ETFs) or mutual funds, and we will discuss the main indexes below. The most popularly cited index in the financial media is the aforementioned DJIA. Started in 1896 with twelve stocks (the only stock that remained in the index from back then was GE), it has grown to include thirty large company, US-based stocks.  The ten largest stocks (measured by market value, defined below) in the DJIA  (as of June 26-27, 2018) are Apple; Microsoft; Johnson & Johnson; JPMorgan Chase; Exxon-Mobil; Chevron; Walmart; Intel; Visa; and United Healthcare.

The DJIA calculates its daily value by taking the sum of the price per share of all constituent companies, then adjusting with a factor that accounts for stock splits and stock dividends. Daily changes in the index are impacted most by the price of certain high-priced stocks. The stocks with the biggest impact on the value of DJIA are the highest-priced stocks. The current top ten are Boeing; Goldman Sachs; United Healthcare; Home Depot; 3M; Apple; McDonalds; IBM; Caterpillar; and Visa. Note that eight of the ten highest-priced stocks are not among the highest in market value.

This focus on price explains why GE was dropped from the index, since its price went as low as $12.61 during the past twelve months (see NYT, 6/19/18, page B2). Notwithstanding this odd methodology in measuring its value, and the fact it only contains 30 stocks, the DJIA is a popular and highly referenced measure of the price changes of the overall US stock market.

In contrast to the DJIA is the S&P 500 index, which contains approximately 500 stocks, making it far more diversified. The S&P 500 uses market value to weight the daily changes to its value. Market value is derived by taking the price per share (constantly changing in the financial markets, and easily obtainable) and multiplying by the number of shares outstanding of the company. The ten largest stocks in the S&P 500 index are Apple; Microsoft; Amazon; Facebook; Berkshire Hathaway; Johnson & Johnson; JP Morgan Chase; Exxon Mobil; Alphabet (Google) A and C.  So, five of the ten largest stocks by market value in the S&P 500 are not included in the DJIA. Apple, as the largest stock in the S&P 500, valued at $900 billion, represents only 4% of the overall value of the index (which comes to approximately $23 trillion at current values). The top ten stocks represent approximately 20% of the value of the index. GE is still large enough by value to remain #40 in the S&P 500, but is only 0.5% of the index value, making it no longer a meaningful component.

The other major US index is the NASDAQ Composite, which is very popular these days because of its emphasis on technology stocks. The top nine stocks by market value are technology-related (counting Alphabet/Google as two), namely Apple; Amazon; Alphabet A and C; Microsoft; Facebook; Intel; Cisco; and Netflix. The total current market value of these stocks is $4.3 trillion, or approximately 40% of the current total index value of $11.6 trillion.

There are also investable indexes for the Total US Stock Market, which tracks between 3,000 and 5,000 large, medium and small cap stocks, contained in all the indices mentioned above, and which represents all US stocks, with a current total value of approximately $30 trillion. One of the funds based on this index (the Vanguard Total Stock Market Admiral Index fund, symbol VTSAX) is a core investment for PPA and its clients.

Other core index investments used by PPA include Developed International (Vanguard fund symbol VTMGX) and Emerging Market International (Vanguard fund symbol VEMAX). VTMGX tracks approximately 3,800 stocks of companies in Europe (52%); certain Pacific region countries, dominated by Japan (38%); and Canada (8%). The ten largest stocks represent 10% of the index, including Royal Dutch (two classes); Nestle; Samsung; HSBC Bank; Toyota; Novartis; BP Petroleum, and Total Petroleum.

Interestingly, Chinese companies are still categorized as emerging market, so the VEMAX fund is dominated by China (20% of value is in Chinese companies, followed by Taiwan with 12% and India with 7%). VEMAX tracks approximately 4,000 stocks, and the largest ten represent approximately 18% of the index, including Tencent; Alibaba; Taiwan Semiconductor; Naspers; China Construction Bank; Taiwan Semiconductor Manufacturing; Industrial and Commercial Bank of China; Badu; and China Mobil.

There are also hundreds of sector index ETFs and mutual funds, allowing investors/traders to focus on specific parts of the overall stock market. In PPA-managed portfolios, we sometimes use a biotechnology stock index fund (symbol IBB) and a real estate investment trust, or REIT, stock index fund (symbol VGSLX), as these sectors are underrepresented in the broad index funds we use as core investments.  Bond funds can also be established and managed as index funds, although many large, diversified bond funds are not strictly speaking index funds.

While the end-of-June numerical value of the DJIA is approximately 24,000, the S&P 500 2,700, and the NASDAQ Composite 7,500, these figures have no bearing on the underlying value of the stocks in the indexes.  Rather, they represent the current figures of all the historical calculations that have been made to arrive at daily changes in value. Most media tend to focus on numerical changes to the indices’ values.

However, rather than focusing on the numerical value, the focus should be on the percentage change in the indexes over whatever period of time is being measured. For example, a 27-point change in the S&P 500 is 1%, while a 200-point change on the DJI is about 0.75%, and a 50-point change in the NADADQ is 0.67%. Note also that all the charts on the last two pages of each Monthly Comments use these three indexes to represent changes in the stock market.

With all this as background, a question arises: why not just invest in the high flying NASDAQ index? The answer comes back to the story of GE. No company or group of companies stays on top forever, even though at the time of their ascendancy it appears that way. The so called “Nifty Fifty” of the 1970s, starring Xerox and Polaroid, and the bankruptcy of General Motors, along with the example of GE, tells us that at some point even the most valuable companies can see their earnings slow down, competitors outperform, or regulatory issues impede growth, in addition to other concerns that may cause the stock price to decline.

At PPA, we prefer investing in the broadest and most diversified indexes, with a few sectors sprinkled in, to avoid the serious declines that can accompany a fall from favor of a few high flyers. In doing so, PPA accepts that it will not outperform the market by emphasizing the current high flyers, but rather should earn the returns provided by the broad-based, market-tracking index funds we use on behalf of our clients.

In our July 2017 Comments, we wrote that….”following Donald Trump’s surprising presidential election victory, the major US stock market indices have registered their own surprising gains, with the S&P 500 increasing from 2,140 on election eve 2016 to 2,470 as of the end of July 2017, a gain of 15.4 %. Without taking any position on the current political situation in the US (other than noting its extremely adversarial nature), many financial observers and investors are wondering how/why stock prices remain at or near all-time highs.”

In these May 2018 Comments, we revisit this same question of why stock prices have remained well above their post-election levels (from 2,140 to 2,705 as of May 31, 2018, a gain of 26%, even with a decline of 6% from the January 2018 all-time high of 2,873), although political dysfunction over serious domestic and global issues seems to be rising. The Economist Magazine makes an effort to explain what is happening:

“Most American elites believe that the Trump presidency is hurting their country. Foreign policy mandarins are terrified that security alliances are being wrecked.  Fiscal experts warn that borrowing is spiraling out of control. Scientists deplore the rejection of climate change. And some legal experts warn of a looming constitutional crisis. Amid the tumult there is a striking exception.  The people who run companies have made their calculations about the Age of Trump. On balance they like it. Bosses reckon that the value of tax cuts, deregulation and potential trade concessions from China outweigh the hazy costs of weaker institutions and trade wars. And they are willing to play along with President Trump’s home-brewed economic vision, in which firms are freed from the state and unfair competition, and profits, investments and, eventually, wages soar. The financial fireworks on display in the first quarter of this year suggest that this vision is coming true.  The earnings of listed firms rose by 22% compared with a year earlier; investment was up by 19%. But as our briefing explains, the investment surge is unlike any before – it is skewed towards tech giants, not firms with factories.  When it comes to gauging the full costs of Mr. Trump, America Inc. is being short sighted and sloppy.”

Note that our purpose in citing the Economist article is to provide some of the current rationales for stock prices remaining at favorable levels in spite of all the political turmoil. We are not presenting the remainder of what becomes a critical article on many of the Trump policies, because this would be beyond the scope of these Comments.

Note also that as these Comments are being written, governmental shifts in Italy and Spain, and the imposition of various tariffs by the US, have given rise to further concerns. These concerns have cited as reasons for one-day stock price declines, but generally they have been followed by one-day recoveries of similar amounts.

Returning to our July 2017 Comments, which quoted Jeff Sommer’s article in the Sunday NY Times Business section  headlined “Political Strife is High, but the Market Doesn’t Care”: “The US is so sharply divided that political consensus appears to fray almost daily. Yet two truths about politics can be demonstrated with hard numbers. The first is that partisan conflict doesn’t just seem to have become more intense this year: It has actually reached new levels of nastiness. The second is that the stock market doesn’t care. In fact, the rising acrimony has been a fine environment for stocks, though possibly detrimental to the economy itself.”  The article concludes that “even in the era of Big Data, some mysteries have not been unraveled with numbers. Right now, the sublime indifference of the stock market (to partisan political conflict) is one of them.”

The July 2017 Comments also presented historical information of troubled presidencies and the levels of the S&P 500 index during those periods. These figures come from a June 2017 “Clients’ Corner” article by Nick Murray, a well-known commentator on investments and advocate for investing in stocks for the long term:

1. Nixon fires Watergate Special Prosecutor, October 20, 1973; S&P 500 closed at 109
2. Carter’s 100^th day in office, end of April 1977; S&P 500 closed at 100 (the Carter presidency “encompassed the second of two huge oil shocks, runaway inflation, and a deep recession.”)
3. Vote on Clinton’s impeachment, December 19, 1998; S&P 500 closed at 1,203
4. US government shutdown during Obama administration, October 1, 2013; S&P 500 closed at 1,695
5. Trump election, November 8, 2016; S&P 500 closed at 2,140; July 31, 2017 close at 2,470

Murray also points out the following record of stock and economic results:  “Over this almost 71 year period (1946 to the 2016 election), the S&P 500 stock index has increased from 15 to 2,140, not including dividends, which have increased from 71 cents to $45, while US GDP has increased from $2 trillion to nearly $17 trillion.”

Murray concludes with the following statement: “If history is any guide, rational capital ultimately outlasts irrational presidencies. And that fleeing capital markets in reaction to distressing political events has in the past never proved to be a lastingly successful investment policy.”

Murray seems to be advocating ignoring the political turmoil, since the historical record shows recoveries over lengthy time periods. We would repeat our comments from July 2017: (1) the 44 years from Nixon’s S&P 500 level of 109 to the current 2,470 comes to an annualized gain of 7.35% (excluding dividends), a reasonable but not extraordinary return; and (2) stock price increases do not occur in a steady, straight line. For instance, in March 2009, at the low point of the stock market after the financial crisis and Great Recession of 2008, the S&P 500 index fell to 677. This decline, from the then previous all-time high of 1,527 during the first quarter of 2000, represented a 56% decline in stock prices, and also reduced the annualized return from 1973 to 2009 (36 years) to 5.2%

It is this potential for significant declines that creates concern for many investors, and which leads us to advocate prudent asset allocations, so our clients can maintain their investment portfolios through the inevitable periods of stock price declines.

Inflation refers to the declining purchasing power of money over time, caused by a general level of rising prices.  In an economy with a 2% annual inflation rate (the favored figure for the US Federal Reserve; see NY Times article cited below), items that cost $10,000 today would have cost $5,000 36 years ago, using that 2% rate. This also means that for people with life expectancies of 36 years, for every $100,000 accumulated currently, you need to have that amount grow to $200,000 just to be able to buy the same items. If inflation rose 4% per year, then prices would double every 18 years, making it much more difficult for investors to keep up (the $100,000 investment portfolio would have to grow to $400,000 just to stay even over the 18-year period). Financial markets in stocks and bonds provide a way to increase assets in excess of inflation.

It is important first to note that no investment result caused this erosion in purchasing power. Rather, central banks seem to have determined that a growing economy can absorb some price inflation, that 2% is a reasonable figure, and that zero inflation would signal an economy in recession. So it is the rising prices in the economy at large that create inflation. In a recent NY Times article discussing the possibility that years of low inflation and low interest rates may be coming to an end, Neil Irwin writes that “if this really is the start of a resetting of inflation and interest rates toward more historically normal levels, it will be mostly good news for the world economy. Central bankers have spent years trying unsuccessfully to get inflation to the 2% level many of them aim for.”

There is a close and direct connection between inflation and interest rates (and changes in bond prices, which are determined by changes in interest rates). Here’s why: a bond is a promise to repay a fixed amount of money in the future, plus interest (think of a bond as an IOU from a company or governmental entity). If the purchasing power of the money received in the future is going to be lower than when the bond was purchased (the definition of inflation), then the interest payments received must at least cover the loss of purchasing power. The interest payments then need to provide some positive investment return above the rate of interest paid to cover the inflation rate.

To put this idea into figures: if inflation is 2%, the interest you earn on your bonds needs to be greater than 2% to allow for some increase in purchasing power when the bond matures and the bond investment money comes back to you. And the longer the maturity of the bond, the higher the interest rate needs to be to compensate the investor for the current risk of future purchasing power. It is less risky to wait two years for the return of money from a bond investment than it is to wait for ten years, which is why interest rates on longer maturity bonds are higher than on short maturity bonds. And when dealing with money markets and other short-term, bond-like investments (e.g. bank CDs), whose interest rates often fall below the inflation rate, investors should be aware they are trading price stability of the investment for declining purchasing power over time.

In the current economic environment, central banks such as the US Federal Reserve (the “Fed”) set the overnight interest rates they control to accomplish a balancing act: keeping rates low enough to encourage economic growth, yet high enough to discourage too much growth, which in turn would give rise to inflation. In this context, inflation means rising prices (the same rising prices that translate into declining purchasing power). Accomplishing this balance is complex and delicate. The current Fed is trying to raise rates from the ultra-low rates in place since the 2008 recession, to more historically normal rates based on inflation of 2% (see Neil Irwin quote above). Every time the Fed raises rates by 25 bp (1/4 of 1%), the other outstanding bonds traded in the financial markets react, typically through declining prices, so that the lower interest rate associated with these outstanding bonds provides the same investment return at maturity as a newly-issued bond with a higher interest rate.  It is always unclear ahead of time how many rate changes the Fed needs to make to have the interest rate level at an appropriate place, neither too low nor too high.

The effect of inflation on stock prices is not nearly as direct as with bond prices. Higher prices often mean more profits for businesses, but higher interest rates increase their expenses. Higher interest rates also negatively impact purchasers who need to finance their large economic transactions, like buying a home or a car. Further, if inflation gets too high, many people are not able to afford the transactions at all, which has the effect of slowing down economic activity.  As Irwin writes in his NY Times article cited above, “If higher interest rates are caused by higher economic growth, that’s a dynamic stock investors would probably be fine with, in that more growth should translate into more corporate earnings. But if the higher rates are being driven by inflationary pressures, that’s a different story, and suddenly the assumptions behind sky high stock prices could fall into doubt…. In the short run, markets can be shaped by all kinds of things, whether algorithmic trading or a run of bad news for a major company or a presidential tweet. But in the longer run, economic fundamentals are powerful forces.”  What the article leaves unsaid, and what is always difficult to determine in advance of the event, is whether the higher rates are driven by good economic growth or not-so-good price inflation.

From an investment standpoint, higher rates make bonds more attractive, which could draw money away from the stock market. Irwin’s article also makes reference to this point: “After nine years of economic expansion and rising stock prices, the stock market is richly valued relative to earnings, making the earnings return on the stock market low. That low return might be tolerable when money invested in an ultra-safe Treasury bond or even in a savings account, generates very low returns,” but as those short-term rates rise, they become more attractive investments to some group of investors looking for safety of their capital, which has the potential of putting downward pressure on stock prices.

As stock and bond prices fluctuate more significantly, inflation will often be used as an explanation. An example is the recent NY Times article on jobs growth (front page, 5/5/18), discussing the low unemployment rate combined with a lack of rapid wage growth, which states that “Hourly earnings went up by 2.6% over the past year, not much faster than inflation.  The subdued wage gains eased the prospect that the Fed would accelerate its plans to raise interest rates.” In any case, inflation is and will remain an important factor in the movement of stock and bond prices.