Health care and politics

Polls indicate that Hillary Clinton now has a 90% chance of winning the election. The fallout of Donald Trump is already having an impact on the markets. Health Care stocks (Vanguard Health Care ETF) plunged 4% this week as investors began to factor in a Hillary Clinton presidency. A few weeks ago, I wrote that markets prefer a split government. Stock market performance has been higher when one party has controlled the White House but not both chambers of Congress. The new concern is that Democrat’s have an outside chance of regaining control of Congress. The change in government would be disastrous for drug companies. Just the mention of a government official calling out a drug companies’ pricing practice will cause their stock to plummet. Yesterday, Bernie Sanders sent a Tweet on Ariad Pharmaceuticals (ARIA), and the stock price immediately fell over 11%!

No CEO wants to see their company lose 11% of its value because of a tweet. There has been a rampant rise of prescription drug costs to the tune of over $2 billion last year. Health Care inflation is out of control. The Affordable Care Act, has also caused premiums to rise for the middle class. Even Bill Clinton criticized Obamacare, calling it, “the craziest thing in the world.” It is too early now to judge whether or not this sell-off has been an overreaction, making this a great buying opportunity.

The meltdown of Donald Trump and his campaign has made this election cycle different than past elections.  According to a recent poll by ABC News/Washington Post, these two candidates are the two most unpopular presidential choices in more than 30 years of polling. I wrote a few weeks ago that I thought market reaction would be somewhat muted to the new presidency, but I’ve changed my view. An unexpected Donald Trump win, I believe would cause global markets to panic. Now that he is running as an anti-establishment candidate, without much support of the rest of his party, the uncertainty level of his administration is off the charts. You know it’s bad for the Republicans when my mother-in-law who has Fox news normally tuned on for 24 hours a day, can’t stand to watch. 

The negativity surrounding politics and corporate America now threatens to spill over into the broader economy.  Last Friday’s jobs report showed slower job growth in higher-wage industries. Businesses are becoming more cautious as managements are now taking a wait and see approach. Stocks fell this week to their lowest level since July as investors digested bad news coming out of China regarding lower than expected exports. We have entered third quarter earnings season and the estimated sales growth rate for the S&P 500 is 2.6%. It is no surprise that the Health Care sector has one of the highest growth rates of 7%.

I continue to believe that markets will remain very volatile. Many of the major U.S technology companies will be reporting a week before the election. While I do have high expectations for most companies to beat earnings this season, I have much lower expectations that politicians will be able to work together after this nasty election.

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Advisory services offered through Constant Guidance Financial LLC, a registered investment

Is another interest rate hike coming?

In 2008 and 2009, the market was in the midst of a massive stock market meltdown and was on the verge of an economic collapse. Since that time, banks have recapitalized, market values have recovered, and consumer confidence is at a 9 year high. The recovery has largely been driven by strong corporate cash flows and stock buybacks. We have just experience an incredible innovative cycle of technology advances such as cloud computing, genetic engineering, artificial intelligence, the creation of an app economy, and the proliferation of smartphone’s.

There has been an ongoing debate about other reasons why economies around the world have rebounded so strongly.  How much of the economic expansion has to do with the creation of leverage and debt? Central banks around the world have issued a massive amount of debt into the system and companies have also raised money through debt offerings. Bloomberg reported the other day that the world debt level is at an all-time high of $152 Trillion.

Over the past two weeks, markets have begun to realize that central banks are going to be much less accommodating. There is a strong probability that the Fed will raise rates once again at the end of the year.  In my September 2016 outlook, I warned that Utilities, REITs, and Telecom stocks were acting as bond proxies because they pay above average dividends. Investors were starving for dividends which created a “yield bubble”. The air has gotten released from the bubble as the Utilities (symbol XLU) and REIT (symbol VNQ) sectors both have seen values drop more than 10% from their respective highs.

Up until now, the higher market valuations have moved in tandem with the issuance of new debt. Economic growth has been low, but there have been signs of inflation. Medical care costs are out of control and home prices have re-inflated. Also, commodity prices are back on the rise and skilled workers are becoming harder to find. In July, job openings hit a record high. The Fed has good reason to raise rates again. I don’t believe that the Fed will be able to raise interest rates without negatively impacting asset prices.

As the Fed increases rates, I’m less optimistic that investors will be able to harvest the same type of returns that they have experienced over the past 5 years. Without the extra liquidity, earnings growth may slow and markets are starting from higher valuations. If the pattern holds, the Fed raised rates at the end of 2015, and they will raise rates at the end of this year. Next year should play out as it did in 2016. There will much discussion about a third interest rate increase, but the Fed will wait once again until they are certain that another rate hike will not hurt job creation. This belief has many implications and may open up new investment opportunities in the coming months.

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Advisory services offered through Constant Guidance Financial LLC, a registered investment adviser.

Losing Trust

The trust placed in our banking system took another hit when Wells Fargo disclosed that they opened up over 2 million unauthorized customer accounts. Before the news broke, Wells Fargo was recognized as one of the most reputable banks. Even Warren Buffett has placed full trust in Wells Fargo. He owns over 10% of the entire company. The deceitful actions taken by the 5,300 employees exemplifies how the culture of the banking system is mired in conflicts of interest. I’ve always known that the conflicts existed at large financial firms, which is why I chose the path to be an independently owned financial advisor.  I never imagined that a bank such as Wells Fargo would go to this length to illegally open up accounts without the consent of their customers.

The trust in the Federal Reserve bank has also recently been challenged. They have chosen to keep interest rates artificially low, which has punished savers. There is much debate that we are in a “yield bubble” and what the consequences will be if the Fed gradually raises interest rates. We are in uncharted territory with interest rates near historical lows. Nobody knows what will happen if interest rates move higher. The current expectations are that interest rates are going to stay low for a very long time. At the September meeting, the Fed couldn’t raise rates 0.25% because of the fear that they would trigger a massive market sell-off.

I believe that the scandal at Wells Fargo and the Federal Reserve interest rate policy have one thing in common. Both policies have had unintended consequences. At Wells Fargo, top management created an incentive structure that led to employees cheating to increase their compensation. In the case of the Fed, the central bankers have set a course that has forced millions of investors to take additional market risks.

The blame will be squarely on the Fed if they are unable to gradually raise interest rates without negatively impacting asset prices. There are signs that the housing market is becoming frothy due in large part of the low rate environment. Utilities, REITs, and Telecom companies have recently sold off from the highs and rates haven’t even risen yet.

Over the next month, all eyes will be watching what might go down as the nastiest election of our lifetime. As soon as the election ends in November, investors will shift their focus on whether or not the Fed will raise interest rates at the December meeting. The uncertainty of a potential interest rate increase in a fragile economy should help to keep market volatility high through the end of the year.

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Advisory services offered through Constant Guidance Financial LLC, a registered investment adviser.

August Monthly Update and September Outlook

August 2016 Review

Over the last few months, I’ve written often on the mispricing of safety-oriented investments. In early August, I recommended that Financials were a good alternative to hedge interest rate risk. At the time, it was easy to spot how the quest for dividends in a low-yield world caused many overvalued investments. Last month, Utilities, Telecom, and REITs all experienced sharp price corrections. The S&P 500 was virtually unchanged in August, but under the surface, investors began to brace their portfolios for a rise in interest rates. Money rotated into the Financial and Technology sectors as investors turned their focus to earnings and valuations. These two sectors had underperformed for much of 2016. The chart below shows the dramatic shift out of Utilities and Telecom.


September 2016 Outlook

I continue to believe that the major risks are political and central bank uncertainty. I’m less worried about the economy and more focused on avoiding investments that will implode once inflation returns. The biggest risk for retirees continues to be low interest rates and the risk of inflation increasing. The lesson learned in August was how low risk, interest sensitive investments can experience significant losses over a short period of time.

I believe that valuations, earnings, cash flows, and asset growth are better metrics that retirees should be basing their investment decisions on.  Owning high-quality companies, that provide stable and growing cash flows, is a better way to invest over the long-term. Unfortunately, these companies are no longer cheap and it is challenging to find attractive entry points to buy. You are now buying high with the hope that these investments will go higher.

I’m no longer bearish on utilities and telecom, but I do believe that these sectors remain vulnerable. After a 8% correction, some of the downside risk has diminished. The U.S. consumer is very strong and this bodes well for future economic growth. Residential house prices are appreciating fast, gas prices are low, 401k’s and retirement accounts are high, and jobs are plentiful. We are in the late stages of the economic cycle when inflation begins to creep into the equation. Price inflation is already present in assets such as stocks, bonds, and real estate. Health Care costs have also risen dramatically and is running at 6-8% per year.

For those living on fixed budgets, rising costs without a hedge to inflation could result in a budget short-fall. For my retired clients, I have slowly adjusted my portfolios into sectors that may benefit from a rise in inflation. For my younger clients, I continue to hold higher quality technology and growth companies.

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Advisory services offered through Constant Guidance Financial LLC, a registered investment adviser.

Are retirees thinking about their portfolios incorrectly? 

The challenge that many retirees face, is constructing a portfolio to meet their funding goals. This challenge becomes even greater with interest rates near all-time lows and market values near all-time highs. Millions of baby boomers are discovering that their nest egg is not going to generate the income that they need to meet their budgets in retirement.

The question that everyone wants to know, is how much money they can withdraw from their portfolio without depleting their life savings. There is only one chance to get this question right.

In retirement, preserving the portfolio while managing for risk is essential for a successful outcome. The reality is that there will be a test along the way from a significant market correction that will cause second-guessing on whether or not the asset allocation is correct.

I believe to make matters worse, more and more retirees have bought into the notion that passive management is a far superior way of investing than active portfolio management. Indexing has become the rage as most major benchmarks have had enormous gains. Leading the way is the S&P 500 (SPY), with an average 15.36% return over the last 5-years. There is no shortage of commentary praising the merits of indexing. Almost a decade ago, Warren Buffett made a million-dollar bet that the S&P 500 would beat the gains earned by a high-powered hedge fund with a team of managers at the helm. It looks as though he is going to win this bet by 40% as the hedge fund managers have struggled.

It goes without saying that investors have very short-term memories. Investing in only the S&P 500 or having a large overweight would have been viewed as imprudent just a few short years ago. For example, a 65 year old, who retired back in 2000 over the course of their retirement years, would have experienced the following 5-year average returns of the S&P 500.

  • Jan 2000 to Dec 2004 = -10.96%
  • Jan 2007 to 2011 = -1.27%
  • Jan 2004 to Dec 2008 = -10.48%

In this example, investing in only the S&P 500 would have resulted in major budget shortfalls 8 out of 16 years. With the market near an all-time high, investing in only passive investments with no focus on active management is not the most appropriate advice for a retiree. This lousy investing advice perambulating the internet is setting up for future disappointment. I believe that diversification through both active and passive investing, with an eye on valuations, is the best way to manage a portfolio. Similar to politics, the best solutions are usually found somewhere near the middle and not at the extremes.

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Advisory services offered through Constant Guidance Financial LLC, a registered investment adviser.

Are bonds still a safe haven?

From July 8th to August 19th, the interest rate on the 10-Year Treasury note has moved from 1.35% to 1.58%.  On July 10th, I wrote that safety-oriented investments were mispriced. As Jeffrey Gundlach said, it was not prudent to buy 10-year Treasurys at these yields, calling them the “worst trade location”.  The overvaluation of “safer” assets was at an extreme level.  Over the last month, the Utilities Select Sector SPDR ETF (XLU) has dropped -3.44% and Vanguard REIT ETF (VNQ) is down -2.50%. As rates increased during this period, the S&P 500 ETF (SPY) returned a positive 1.09%.

Many prominent investors continue to sound the alarm on the potential losses that will occur if central banks are forced to act sooner as inflation increases. A few Fed officials this week are signaling that there may be another interest rate increase this year. Even former Federal Reserve Chairman Alan Greenspan believes that interest rates will begin rising soon, perhaps rapidly. “I cannot perceive that we can maintain these levels of interest rates for very much longer,” he told former Securities and Exchange Commission Chairman Arthur Levitt in a Bloomberg Radio interview .  He added, “They have to start to move up and when they do, they could move up and surprise us with the degree of rapidity which may occur.”

In a CNBC article this week, Paul Singer’s Elliott Management, which has $28 billion in assets, warns that the bond market is “broken” and that when the central bank actions of recent years no longer ward off a market downturn, the subsequent loss of confidence could be severe. He continued that today’s environment marks “the biggest bond bubble in world history,” and “the global bond market is broken.”

Bond are no longer an asset class that is a “safe haven”, yet many investors are still buying bonds for this reason. Below is a chart of the weekly bond fund flows, and it shows that throughout 2016, investors have been steadily buying bonds.

bond fudn flows

Source: Yardeni Research, Inc.

It is a very challenging investment environment for retirees or for those planning for retirement.  With $13 trillion of the world’s sovereign debt trading below 0%, there is much less of a chance for higher future returns. Prudent asset allocation will be critical to achieve their goals. My concern is that losses in the bond markets will spill over into the equity markets. So far, money has not left the markets but has been rotating into growth stocks. The Nasdaq posted its first 8-week win streak since 2010. This has been a great trend for growth stocks, and I continue to believe that there is more potential for upside.

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Advisory services offered through Constant Guidance Financial LLC, a registered investment adviser.

Investing in a Lofty Market

This is an unusual market where stocks, preferreds, and bonds appear fully valued. It is even difficult to find many good opportunities in alternative investments such as real estate. Conservative investors have achieved above-average returns this year and I believe that this trend is unlikely to continue.

At the start of the year, I could buy a conservative preferred stock at a yield-to-call of 6%. This same preferred is now trading at a yield-to-call of 4%. There is no appreciation left in this security. Safe havens for investors to park cash for an above average yield is not without a higher degree of risk. The best tactic to invest in lofty markets is to dollar cost average and focus on the total return of the investment.

Dollar cost averaging is useful when it’s difficult to determine a good entry point into an investment. By investing a fixed amount of money in a consistent manner over time, there will be less regret of making a poor investment decision if markets suddenly drop. There is much debate whether dollar-cost averaging actually reduces risk. Vanguard research wrote a white paper in 2012 and concluded that dollar-cost averaging just means taking risk later. They wrote that investing a lump sum immediately to gain exposure to markets was the prudent action. Their research showed that on average, lump sum investing beat the dollar-cost averaging approach two-thirds of the time.

In my article last week, I wrote how the game rules are changing for asset allocation due to the manipulation of interest rates by central banks. There is close to a staggering $11 trillion dollars worth of bonds with negative interest rates overseas. I also believe that dollar-cost averaging might be the more prudent action than investing a lump sum. Taking some risk now and some risk later is a better tactic in this fully valued market.

It is also important to make a distinction between total return and income yield. Many bonds and dividend paying stocks are not compensating investors for the risk that they are taking. This lofty market also has many investors concentrating their portfolios on a high yield and not total return. Investors that are chasing yields will be at more risk when interest rates begin to rise.

Stocks can justify these valuations as along as the consumer keeps spending, oil prices stay low, and job growth remains strong. In this lofty market, I’m recommending to my clients with new money, that the best tactic would be to dollar-cost average and focus on total return.

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Advisory services offered through Constant Guidance Financial LLC, a registered investment adviser.

Game Rules are Changing

The old rule of thumb was that retirement savers should subtract their current age from 100 to determine the percentage of stocks that they should own. For instance, a 65 year old should have 35% of their portfolio in equities. I believe today’s generation of baby boomers needs to own more stocks. In the past, a retiree could generate living expenses by reinvesting matured bonds at 5-6%. Unfortunately, low quality junk bond now have yields at this level.  Retirement savers unwilling to take risk have found themselves in a quandary on how to generate enough income to maintain their lifestyle.

Every day there are dire warnings to get out of stocks, but markets continue to rally. The S&P 500 closed at an all-time high on Friday. Investment guru’s such as Jeffrey Gundlach and Bill Gross recommend that you should “sell everything”.  Gross wrote in his August monthly commentary that we are in a high-risk, low-return stock market. Goldman Sachs also sounded the alarm on equities earlier in the week and recommended cutting exposure. On Tuesday, Donald Trump said you should sell your entire 401k.

As always, my thoughts on these predictions can best be summed up in a Warren Buffett quote,

“A prediction about the direction of the stock market tells you nothing about where stocks are headed, but a whole lot about the person doing the predicting.”

At some point, I promise you that all of these warnings will come to fruition. I just don’t know the ‘when’ part. If Buffett can’t time the top, I’m sure nobody else has a chance. In the last few months, there has been a melt-up and not a meltdown.

On Friday, the strong July jobs report triggered another 175 point plus rally in the DJIA. Even though markets have made such a strong move, stocks are not expensive. I continue to believe that the major risk is in the bond market and also holding too much cash. The value trap is in sectors that offer no growth and high dividends. Utilities and REITs are two areas that I’m avoiding. With markets at all-time highs and strong job growth, there is a chance that interest rates could begin to creep higher over time. Bonds are vulnerable if the economy continues to strengthen. The old rule of thumb to determine an appropriate asset allocation might not work so well in the future.

For my retired clients, I have slowly adjusted my portfolios away from bonds and into equities. There are other ways to diversify a portfolio without following the old rule of thumb.  Financial stocks stand to benefit if interest rates continue to rise. I believe that this sector offers the best value and is a good way to hedge a portfolio with a large allocation of bonds.

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

Advisory services offered through Constant Guidance Financial LLC, a registered investment adviser.

2Q Earnings Season

It’s earnings season. A high number of companies have beaten their sales and earnings estimates. However, they are clearing a low bar as overall earnings have slightly declined year-over-year. On Friday, GDP for the second quarter, came in at only 1.2%. Even though GDP levels are anemic, there are reasons for optimism. According to CNBC, “consumer spending showed a robust 4.2 percent gain, the best number in a year and a half.”

The other reasons for optimism include housing starts are expected to return to 2007 pre-recession levels, gas prices are at the lowest level in 10 years, and low mortgage rates are helping households to lower their monthly payments. The positive wealth effect of rising asset prices is increasing the premium to own stocks. The trailing 12-month P/E ratio for the S&P 500 is 19.4, which is well above historical averages of 16.5. The Fed continues to punish savers who are unwilling to take risk. In this low interest environment, retirees have been forced to get into the markets. This is a difficult position for many people with low risk tolerances. Low interest rates have forced investors to chase dividends.

The bear case is that businesses have not increased their corporate spending. More companies are using their free-cash flow to buy back shares and/or raise their dividends rather than reinvest for the future. With economic growth so low, management teams are manufacturing earnings growth by lowering their shares outstanding. This has helped to boost earnings per share. The downside to lower business spending is that employment growth for the second half of the year may slow.

Over the last month, the subtle trend has been money rotating from value into growth companies. The mega-cap growth companies such as Google, Facebook, Amazon, Apple, Microsoft – all exceeded their earnings targets this quarter. Biotechnology stocks have also smartly rebounded. Growth has returned to favor.  As I have written over the past few months, I continue to believe that there in more risk is above average dividend paying companies than growth companies. My expectation going forward is that lower risk companies, which have been historically perceived as safe haven investments, will underperform companies that are reinvesting back into their businesses. I will continue to add more companies with above average growth rates and lower my allocation to interest rate sensitive investments.

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

Advisory services offered through Constant Guidance Financial LLC, a registered investment adviser.

Market roller-coaster

The U.S consumer is very healthy and is in a spending mood. The “wealth effect” is a psychological phenomenon when people spend more as the value of their assets rise. House prices and stock prices are now near all-time highs. People are feeling more financially secure and have begun to increase their spending. The result is consumer price inflation.  The annual rate for June was above 2%.

Last week, I warned that the 10-year U.S Treasury was very vulnerable to a price correction. This week the 10-year Treasury moved from 1.40% to 1.60%. Yields turned higher when the Bank of England surprised the markets by not lowering rates. The expectation was for a cut, but they held off because the market reaction since the UK referendum has been less acute than expected. Global markets around the world have rebounded and the pound has stabilized for the moment.

I believe that markets are beginning to look rich, but could continue to go higher if the consumer stays in a spending mood. The market volatility for the first half of the year has been like a roller-coaster and there is no reason why the ride shouldn’t continue into the second half of the year. There already have been three dramatic sell-offs followed by subsequent massive rebounds. Going forward, politics and terrorism are the two biggest risks that the market faces.

The safe bet in 2016 has been investing in high quality U.S businesses that pay strong dividends. The search for high dividend stocks should continue because of the $12 trillion in government bonds with negative yields. This hunt for yield will end when central banks begin to hike interest rates but this shouldn’t happen until next year. The wildcard here is that central banks are forced to act sooner if inflation increases.  This is possible given that massive stimulus has been pumped into the global economy and there is no end in sight. It is clear to me that inflation is causing price appreciation across most major asset classes.

There are many scenarios that might lead to another massive sell-off. A common phase that has been spoken often this year is, “this world has gone nuts”. If the current pattern persists, markets will again be blindsided by some unexpected event. I believe that you need to take a balanced approach in the current investment climate.  A portfolio tilted toward quality with a bias to the U.S might be less vulnerable to an external overseas shock.

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

Advisory services offered through Constant Guidance Financial LLC, a registered investment adviser.