How has the banking system changed over the last decade?

This week many of the major U.S banks reported earnings. These quarterly reports were exactly what they should be for a bank, which is very boring. They are reporting higher revenue and earnings than 1 year ago.  U.S. banks have now become cash cows.

There are still many investors who believe that banks can’t thrive when interest rates are low. These investors have failed to realize that the low interest rate environment has been a boon for profitability. Even though interest rates have been very low, banks are extremely profitable. In the past, banks had trouble making money when interest rates were low. This was because of something called net interest margin. The net interest margin for a bank is the interest rate spread between deposits and loans. The higher the spread, the higher a bank’s profits. This spread is very important for a bank. Banks can create more profit by borrowing cheap in the short-term and lending high in the long-term. They prefer a larger yield differential, or a “steeper” yield curve.

Bank stocks will tend to rise on days when interest rates rise. I believe that this is now the incorrect way to value a bank. If banks had it their way, they would prefer for the economy to be exactly the same way as it has been for the past 5 years. It is much more important that there is stable employment and a strong housing market. The low interest rate and slow growth economic backdrop have been a great combination for a bank’s profitability. Banks can now generate more income from fees and they rely less on the spread between interest rates.

Ten years ago, before the credit crisis hit, banks were highly leveraged, had lower capital ratios, and they didn’t have solid underwriting standards. Now fast forward a decade, banks have rebuilt their balance sheets, have tightened lending standards, and have diversified their revenue streams. The operations inside of a bank have also become much more efficient. Banks have closed branches, lowered headcount, while continuing to invest into technology.

A well-known bank analyst reported that banks are swimming in so much excess cash that they don’t know what to do with it. Most banks have been returning cash to shareholders in the form of rising dividends and share buybacks. The largest U.S banks are now buying back shares at a greater rate than many cash rich technology companies.  I expect that this pace of buybacks and dividend increases will only increase over the next few years.

I will continue to favor banks as long as the housing market stays strong and the unemployment rate remains low. I’m much less focused on falling or rising interest rates than most other investors. The banking system has helped to facilitate economic growth and should continue to do so as long as banks keep their future earnings reports very mundane.

Please read our disclosure statement regarding the contents of this post and our website as a whole.


It’s Christmas in July! This week my two teenage daughters were shopping on their iPhones like the other tens of million of people on Prime Day 2017. Amazon’s 2017 Prime Day sales increased 60% over the same period last year and more new members joined Prime on July 11 than on any single day in Amazon history.

Amazon has not only disrupted the retail sector, they are now disrupting the entire economy. According to Bank of America Merrill Lynch strategist Michael Hartnett, “Amazonification” of Main St is killing wages, causing Japan-like deflation. While most of the cable news media continuously pound President Trump, the real story this year has been how Amazon and a few other innovative companies are reshaping our entire economy.

Just a rumor of potentially competing with Amazon can send a company’s stock down sharply. On Monday, Zillow’s stock fell 4% after a “Hire a Relator” link suddenly appeared on Amazon’s website. According to Investopedia, the page, which was later taken down, was reportedly located in the Home and Business Services section, a part of Amazon’s website dedicated to connecting customers with experts in home improvement, electronics installation, and various other services.”

Best Buy also saw its value drop by over 7% Monday when Amazon took aim at launching their own version of Geek Squad. Amazon will be offering their own in-house experts.

The entire retail sector has been in a brutal bear market. It is telling that my two teenage daughters were on their phones shopping, rather than at the mall. The mall stocks have gotten pummeled this year. The loses are staggering. Here is a sample of a few retail names that you are familiar with returns through last Thursday (7/14/17) –

J.C. Penney – Down 40%

Express Inc – Down 39.9%

Macy’s Inc – Down 38%

Abercrombie & Fitch – Down 25%

Urban Outfitters – Down 35%

Foot Locker – Down 31%

GNC Holdings – Down 28%

Kohl’s, Target, American Eagle – All down around 20%

The S&P 500 Retail ETF has fallen more than 10 percent over the past 12 months, compared to the S&P 500’s, 14 percent gains. If there were a S&P 500 Mall ETF, it would probably be down over 20%.

I think of this quote by Sir John Templeton’s when markets go to extremes, “Bull markets are born on pessimism, grow on skepticism, mature on optimism, and die on euphoria”.

There couldn’t be more pessimism in the market for retail stocks. Most of these companies are now closing stores and reinvesting back into ecommerce. For instance, Nordstrom’s noted on their last earnings conference call that nearly one-quarter of their sales are from online purchases compared to roughly 5% from 10 years ago.  According to digitalcommerce360, Best Buy’s web sales grew 20.8% for the fiscal year which ended Jan. 28 and totaled $4.85 billion. Best Buy Co. Inc.’s online sales grew at a faster clip than the U.S. e-retail industry average in 2016, and they outperformed online leaders Inc. and Wal-Mart Stores Inc.

This pronounced trend towards ecommerce has been a major reason why the technology sector has been on such a tear. Many companies are now investing in technology for their very survival. I expect that the Amazon effect will push next year’s technology budgets to their limits. I’m spending more time researching for those companies that I believe will benefit from these apparent trends and selectively buying into undervalued companies that can either protect their business from Amazon or successfully differentiate their business from the threat of Amazon.

Please read our disclosure statement regarding the contents of this post and our website as a whole.

The Importance of Liquidity

This week a client asked me a great question in response to an investment that I recommended to him. He wanted to know how liquid the investment would be if the markets headed south. My answer to him, for this particular investment, was it matters why markets were crashing.

The stock market and the housing market are now both higher than they were in 2007 when the economy almost failed. The Great Recession started out as an economic slowdown marked by massive job losses, and then morphed into a liquidity event. Without the government bailout and subsequent money printing by the Federal Reserve, I highly doubt the economy would have rebounded as sharply as it did.

There have been a number of “flash crashes” in recent years, which were all the result of liquidity disappearing overnight. Other recent events included the BREXIT vote and the shock on election night when the markets woke up to the fact that Hillary would not be President.

On Wednesday, Bank of America rang a warning bell regarding all the money that has piled into passive exchange-traded funds. According to CNBC, “The bank says the massive popularity of ETFs may be leading us on a road to a liquidity problem. The note issued by Bank of America, Merrill Lynch’s Global Research department warns “the actual shares available, or true float for S&P 500 stocks, may be grossly overestimated. That could lead stocks and the overall market to fluctuate more violently, especially to the downside, due to a future event affecting either a single stock, a sector or the market at large.”  Joe Terranova, the chief market strategist for Virtus Investment Partners, which manages $25 billion, said, “The danger is when the market falls. Liquidity will evaporate.”

Here is another quote from the leading story in this week’s Barron’s Magazine – “We still call it a stock market, but these days it has many more indexes than it does stocks: There are nearly 6,000 indexes today, up from fewer than 1,000 a decade ago. Meanwhile, the number of stocks in the Wilshire 5000 Total Market Index has shriveled to 3,599, from 7,562 in 1998.”

Below is a chart from the same Barron’s article.

This is the #1 fear that is now very well understood by investors. The #2 fear is if interest rates become unstable and rise sharply. Since June 26th the 10-year Treasury yield has risen from 2.12% to 2.40%. The 10-year yield would need to go over 3% before investors take note. The #3 fear is best summed up with the following quote by Donald Rumsfeld, “…there are also unknown unknowns. There are things we don’t know we don’t know.” It’s the unknown event not anticipated by the market which will likely cause the next liquidity crisis.

It is difficult to predict when the distortion of the market causes a liquidity event. The Man vs. Machine debate will continue and it will only grow louder as passively managed funds gain more and more assets. If the popularity of indexing continues for years to come, I believe that it will be the computers that exacerbate the next market crisis. It is a very interesting debate and even concerns Vanguard founder Jack Bogle, who created the world’s first index fund. He warns, “the implications of this rapid trading in ETFs “have yet to be fully examined.” I believe that we might have to wait until interest rates are much higher before the implication of ETFs can be fully examined.

Please read our disclosure statement regarding the contents of this post and our website as a whole.

One Strike on Technology

Among other negative tweets this week, President Trump took a shot at Amazon and Jeff Bezos.

The #AmazonWashingtonPost, sometimes referred to as the guardian of Amazon not paying internet taxes (which they should) is FAKE NEWS! — Donald J. Trump (@realDonaldTrump) June 28, 2017

As everyone has figured out by now, President Trumps tends to go on the attack in order to distract the media from the real news. The real news this week was that the Republicans were unable to pass major healthcare reform. They need to pass this legislative before they can turn their focus on infrastructure spending and tax reform.

The attack on twitter left many wondering what President Trump meant by ‘internet tax’. There is no such thing as a ‘internet tax’. Amazon does collect sales taxes in every state that has a sales tax. The shot across the bow of Amazon was aimed at its founder Jeff Bezos, who owns the Washington Post. Amazon doesn’t directly own the Washington Post, but Jeff Bezos bought the company for $250mm in 2013. The Washington Post has broken many stories against Trump. This tweet was most likely inspired by the Post‘s recent story about a fake TIME magazine cover featuring Trump hanging in some of the president’s clubs.

Last week, I wrote how the advances in artificial intelligent were beginning to displace jobs across every industry. More and more white collar and blue collar workers alike are beginning to lose sleep over how their jobs can be replaced by technology. President Trump has continued to promise 3-4% GDP growth. I don’t expect him to meet this ambitious growth target unless he can either stop the disinflationary effects of technology or pass legislation for infrastructure spending and tax reform. My concern is that if President Trump is unable to accomplish this legislative agenda then he will be forced to attack technology companies. President Trump has influenced some manufacturing to return back to the U.S., but more companies are saving on labor by automating their plants. Amazon has been the biggest disruptor as it has displaced hundreds of thousands of retail jobs. A look inside an Amazon warehouse would reveal more robots than humans. The same goes for new automotive plants.

The European Union is one step ahead of President Trump. This week they slapped a $2.7 billion record fine on Google over charges the company unfairly elevated its Google shopping business over competitors’ advertisements. The statement from the European Commission was as follows:

“What Google has done is illegal under EU antitrust rules. It denied other companies the chance to compete on the merits and to innovate. And most importantly, it denied European consumers a genuine choice of services and the full benefits of innovation.”

The attacks on Google, Amazon, and failure to pass healthcare reform caused the NASDAQ to drop -2.55% this week (QQQ ETF). I consider major technology companies such as Google, Amazon, Facebook, Netflix, Tesla, Microsoft, Intel, and Apple as emerging monopolies. It just so happens that these companies comprise a large part of the S&P 500 index, and are largely responsible for the above average investment returns over the last year.

These same companies will also benefit the most from any major tax reform. I expect the technology sector to remain volatile as investors weigh the odds of President Trump achieving major legislation vs. the chance that other governments will begin to reach into the pockets of cash rich monopolist technology companies with record fines.

Please read our disclosure statement regarding the contents of this post and our website as a whole.

Here come the Robots

Jeffrey Gundlach is the chief executive officer of DoubleLine Capital whom I quote often in my blog. The other day in his introduction to the Fixed Income Analyst Hall of Fame, he singled out so-called robo-advisers, which provide online portfolio management using little human intervention, as a dangerous bet.

“It’s a one-size-fits-all financial solution,” he said. “Everybody gets the same portfolio, which means everybody owns the same stock, which means when they all decide to get out it causes a crash.”

Gundlach is worried about investors’ herd mentality. There has been a surge into passive investing. As an active manager who believes in fundamental analysis, I share his concern. Artificial intelligence is not only disrupting the investment management business, it’s disrupting ALL businesses. Even the cashiers job at McDonald’s isn’t safe. McDonalds has plans of replacing 2,500 human cashiers with digital kiosks.

This week on “Mad Money” Jim Cramer interviewed IBM CEO Ginni Rometty and much of the conversation was about artificial intelligence in the technology world. IBM is pushing the boundaries in AI and has bet it’s future on a computer named after its first CEO, Thomas Watson. Your life or a family members might one day depend on Watson diagnosing how to treat a major illness such as cancer.

My top investment opportunity for 2017 was investing in companies that are innovating in AI. There have been tremendous gains in technology companies this year and the pace of change is much faster than I even anticipated. Technology companies have been the best performing and many have been leading the charge into AI. The worst performing sector of the market this year is the Energy Select Sector SPDR® Fund, which is down -14%, and the PowerShares QQQ ETF is up almost 20%. In the past six months, the 34% difference in return between sectors is extraordinary.

The energy industry is a capital-intensive business and is much less profitable at lower energy prices. On the other hand, the digital kiosk at McDonald’s has no labor and limited capital costs. The cash flows for technology companies have shown the most growth. The drop in oil prices and the capital appreciation in technology have been the major market trends for the first half of the year. At some point, the pendulum will swing the other way, but for the moment, the growth has been investing in technology companies.

Please read our disclosure statement regarding the contents of this post and our website as a whole.

Inflation Targeting and Politics

The Federal Reserve voted this week to raise interest rates by 0.25%, which was the second increase this year. Federal Chair Janet Yellen said that their decision to raise rates was a reflection of the progress that the economy has made.  Her two main points for raising rates were the 4.3% jobless rate at a 15-year low, and wage growth remaining weak. In her prepared remarks after the decision, Yellen stressed that there is an emerging debate over raising global inflation targets, which is now one of the Fed’s most important questions facing monetary policy.  Since early 2012, the inflation rate has been running below the Fed’s 2% target. In April, the inflation rate dropped to 1.7%.

There are many economists who believe that U.S growth is weak and that inflation should be increased to spur higher growth. I disagree with these shortsighted economists. I’m not sure how the economy can be weak if almost all the major stock indices are up over 15% in the past year. Moreover, there are now bidding wars breaking out in the real estate market. House prices are actually higher than they were before the entire economy system almost failed and needed a government bailout. The major differences between 2008 and now are that banks are well capitalized and borrowers are more creditworthy. The stock market has risen as corporate profit margins have increased. It’s been a very good investing environment and I don’t want any changes to inflation targets.

In addition, I know that all of my clients in retirement need lower inflation because of their fixed incomes. If the Federal Reserve does change their target to say 3%, the result will be that millions of retirees suddenly will be in a budget shortfall. Yellen believes that interest rates have been stuck at historically low levels and unless something changes around inflation targeting, growth will remain weak. She said that changing this inflation target “is one of our most critical decisions.” This is unwelcome news that the Federal Reserve does not believe that higher inflation is a major risk to investors.

When I create a retirement plan and change my inflation assumptions from 2% to 4%, the probability of a successful retirement drops substantially. It’s the real return that matters the most for investors. I prefer a lower inflation rate and a chance to make a higher return investing in stocks, bonds, and preferreds. I hope that the Federal Reserve can remain independent from Washington, keep to their senses, and continue to target an inflation rate of 2%. Regardless of your political affiliation, we don’t want any elected government officials playing politics with inflation targets in order to increase economic growth. The economy is running well and it will be best not to trigger higher inflation.

Please read our disclosure statement regarding the contents of this post and our website as a whole.

Beware the Market Hypothetical

Professionals and individuals alike make major financial decisions based solely on past investment returns. This is a huge mistake. Given that the average 5-year return of the S&P 500 now stands at 15%, these hypothetical returns show unrealistic promises of high returns.

Most financial advisors use market hypotheticals in their presentations to make the case that their investment model is superior.  They hope that the unsuspecting investor will ignore the warning “past performance is not an indicator of future outcomes” in fine print and will chose the investment or financial advisor that shows the greatest return potential.

Throughout my career, I’ve seen the worst investment mistakes made when people chase past performance. Here are five helpful tips on how to avoid this mistake:

Gimmick – There is a very large presentation book filled with charts and graphs that show hypothetical performance and no actual performance.

Tip – Make your decision based more on the investment philosophy and experience of the advisor or firm who will be managing the money. Is the investment process repeatable? What are the qualifications of the advisor?  

Gimmick– A mutual fund fact sheet is shown with very high returns.

Tip – Ask the advisor for the worst 1, 3, and 5 year returns for that same investment. 

Gimmick – A model portfolio based on risk and no actual returns is presented.

Tip  – Request to see actual returns of clients. If real returns are not available, ask to see a client reference list.   

Gimmick – A proprietary mutual fund is selected by the financial advisor. This is an investment managed by the company that you are meeting with.

Tip – In 99.9% of the cases, this mutual fund has much higher expenses and has likely underperformed its benchmark. Ask to see if there is an exchange-traded fund equivalent with lower fees and higher returns.

Gimmick – An annuity is recommended by showing you hypothetical returns with income expectations for life.

Tip – Request to see what the total expense will be for that annuity over a 5 and 10 year period. Determine when the original investment principal is exhausted. 

At this point in the market cycle, investors need to be very cautious on selecting their investments based on past returns. I have seen more and more hypothetical investments from other financial advisors that will not be repeated. It is very easy to construct models that are backward-looking and misleading. My recommendation is to tear them up and recycle the paper.

Please read our disclosure statement regarding the contents of this post and our website as a whole.

5 Ways to De-Risk a Portfolio

Christine Benz is Morningstar’s Director of Personal Finance. She writes a weekly column called, “Improving Your Finances”, on I consider Christine’s advice the best and most reliable that you can find online. She writes on timely topics that are relevant to her followers.

This week she discussed 4 Ways to De-Risk a Portfolio in Retirement. As always, I was in complete agreement with her advice. In fact, many of the investments that she recommended, I already own for most of my clients in or near retirement. Her four ways to de-risk a portfolio are higher dividends, diversification, timely rebalancing, and investing in high quality stocks.

Many smart investors have already taken Christine’s advice and are de-risking their portfolios. They are rotating out of the U.S., buying high quality companies with no debt and strong cash flows, favoring dividend paying companies, and diversifying into bonds. The investors who don’t heed this advice are going to experience the most financial pain when the correction does hit.

Bloomberg’s chart of the week showed the companies with the highest debt are vastly underperforming the market.  If you remove the “FANG” stocks (Facebook, Amazon, Netflix, Google), the companies with the highest debt trail the market this year by 14%! This same market action occurred during the lead up to the Great Recession in 2008. The market is also becoming very narrow, and if you remove the FANG stocks, the S&P 500 year-to-date return drops from 9% to 4%.

This week, Seth Klarman, who I believe is the 2nd greatest living investor behind Buffett, couldn’t have written a better statement that summarizes the current risk level of the market:

“When share prices are low, as they were in the fall of 2008 into early 2009, actual risk is usually quite muted while perception of risk is very high. By contrast, when securities prices are high, as they are today, the perception of risk is muted, but the risks to investors are quite elevated.”

There is more truth in these two sentences than anything I’ve read in a very long time. In the last 10 years, Seth has grown his hedge fund from a few billion to over $30 billion. He also wrote an investment book years ago that now sells for over $900 on Amazon. He is one of the few investors that bet against the housing market and he correctly anticipated the subsequent crash.

He considers cash a major part of his asset allocation. I’m sure that he would add cash as the 5th way to de-risk a portfolio. He keeps liquidity high and understands the potential downside of his investments. When the correction strikes, the most leveraged companies typically fall the fastest. Warren Buffett’s summed up excessive risk taking best with this famous quote, “Only when the tide goes out do you discover who’s been swimming naked.” The companies with the most debt or the investors who purchase illiquid investments are usually the ones caught swimming naked.

I’ll continue to help my clients stay invested in the market, while, at the same time, de-risking their portfolios, and keeping my clothes on!

Please read our disclosure statement regarding the contents of this post and our website as a whole.

Digital Currency Mania

In February 2017, one Bitcoin was worth around $1,000, and this week it touched a high of $2,800! The 52-week low for a Bitcoin is $447. This Memorial Day, at the cookout, I’m sure there will be many conversations around politics, technology stocks, sky high house prices, and Bitcoin.

In full disclosure, I have owned Bitcoin and set-up a Coinbase account years ago. I even looked into mining for new Bitcoin. At this point, I’ve probably lost you. What is mining? What is a Bitcoin? What is Coinbase?

Bitcoin is a digital currency. It was created on a network of computers called a blockchain. Rather than getting into the technical language on how a blockchain is created and why Bitcoin exists, I’m going to touch on what I believe is most important to your cookout conversation. If you want all the specifics on Bitcoin, you can click here.

As early as 2011, you could connect your desktop computer into this Bitcoin network. The founders of Bitcoin were not in it for the money. For those people who mined for new Bitcoin, it was a hobby that they did for fun. If one of these computers plugged into the network, helped to make a transaction between a buyer and seller, a Bitcoin would be rewarded into a Bitcoin wallet. In the early days, Bitcoin miners would lose money on each transaction because it cost more money to power your computer than what a Bitcoin was worth. As more computers joined the network, it became harder for a desktop computer to win new Bitcoin. The higher powered computers were rewarded more and more Bitcoins. As Bitcoin increased in value, the energy costs became a small fraction of the potential profit. It became so profitable that entire data centers were built to mine for new Bitcoin. These computers cost upwards of $10,000. The technology was moving so fast that a $10,000 computer would be worthless in only a matter of a few weeks time, as faster computers came to market. If you couldn’t afford a Bitcoin miner, you could buy fractional ownership of one online. Investors began to see the value in building the computers and not in the Bitcoin. If they could get enough fractional ownership, they would make money regardless of the price of Bitcoin.

New exchanges and digital currencies were created overnight. There are now hundreds of digital currencies all competing to become the next lottery ticket. Coinbase is the exchange where you can buy and sell Bitcoin. Many of the exchanges were shutdown because of fraud and only a few major ones survived. The speculation on these exchanges is 100x higher than at a Foxwoods roulette table. There is a dark side to Bitcoin exchanges and your money is never 100% safe.

These virtual currencies are used to launder money, finance terrorism, and other illegal activities. It would disgust you that there are many criminals and mafia members that have made millions on Bitcoin. This was one of the major reasons why I stopped trading Bitcoin.

Bitcoin has yet to be recognized as a major currency, but most major retailers recognize Bitcoin as a legal form of payment. The reason for the huge move in Bitcoin over the past month is pure speculation that more buyers are about to enter the market. If an exchange-traded Bitcoin fund is approved, it will add to the mania. I believe that this frenzy reached its apex as speculators around the world were joining in on this newly created bubble. These Bitcoin traders that are late to the party will lose the most money. The early buyers of Bitcoin are not selling, which makes this bubble so interesting to me. They believe that a Bitcoin is worth over $10,000 and not $2,800. While I don’t believe that Bitcoin is worthless, it is showing signs of a classic market bubble.

Happy Memorial Day, as we remember with pride those friends and family members who served and died for our freedom.

Please read our disclosure statement regarding the contents of this post and our website as a whole.

Amazon’s Lesson

In 1993, Warren Buffett used $433 million in Berkshire Hathaway stock to purchase Dexter Shoe. In his 2007 letter to shareholders, Buffett explained that this poor decision was magnified because he used the company stock to make the purchase. Warren wrote, “To date, Dexter is the worst deal that I’ve made. But I’ll make more mistakes in the future — you can bet on that.”

It’s easy to reflect on all the “what if” investments that each of us have missed. Economist Larry Summers summed it up best with this quote, “Most investors want to do today what they should have done yesterday.”

It is always clear to look back at the “misses”. This week marks the 20th Anniversary of Amazon going public. A $1,000 investment on the day of May 15th 1997 would be worth around $638,000 today. A few weeks ago, Buffett was asked on CNBC why he didn’t buy Amazon shares, and his answer was simple, “Stupidity”.  Amazon’s amazing success has disrupted the business model of the entire retail industry. First, it was the bookstores, and then they bankrupted countless other competitors. This earnings season especially the market has been punishing many retail companies that are showing signs of slowing revenue. It is not uncommon to see companies lose over 15% of their value overnight.

Numerous investment lessons can be learned from studying Amazon’s phenomenal success. There is one in particular that I believe is critical to investment success.

A company that continuously grows revenue is much more valuable than a company that is generating profits but has no revenue growth. There are many retail companies that pay above average dividends; however, these stocks have been decimated because of lost revenues to Amazon. On the contrary, Amazon pays no dividend and has never shown any real profits. They reinvest all of their profits back into the business to generate even higher revenues.

There are many investments that appeared cheap on valuation, have substantial cash flows, strong balance sheets, and great dividends. In spite of these justifications to purchase these stocks, I would consider them value traps. With no revenue growth, falling profits will not be far behind. I consider avoiding these types of investments much more important than making decisions based on the daily political games being played out in Washington. I remain much more focused on which investments offer the best future revenue growth.

Please read our disclosure statement regarding the contents of this post and our website as a whole.