The Danger And Limits Of A Virus: Notes On The COVID-19 Outbreak

My grandfather, my mother’s father, Charles H. Magill died in the flu pandemic of 1918.  Ironically, he did not die from the flu.  He died from an overdose of drugs administered by a doctor.  There was no Food and Drug Administration (FDA) in those days.  Doctors had to decide for themselves the appropriate dosage.  My mother was three years old at the time.Now we are visited upon by another virulent contagion.  The world is much more populated now than in 1918 by a factor of about five.  Science and communications make the spread of the virus much more anticipated. However, because it was not anticipated, there is no vaccination for the current outbreak, labeled COVID-19.  Nor is there a remedy, aside from contracting the virus and surviving. The effect on the stock market has been pandemonium.  There is an old adage on Wall Street that markets take an escalator going up, but the elevator going down.  Program trading has exacerbated this.  In 1987, program trading caused the stock market to fall 25 percent in a day. So far, the market has fallen about 33 percent from its peak February 19, 22 days ago.The problem with program trading is that it assumes there is someone on the other side of the trade.  This is technically known as liquidity.  When liquidity dries up, and there is no one to bid or offer at the last trade price, look out below.  Markets used to be supported by specialists and banks trading their own accounts.  Specialists were supposedly made obsolete by computers, and banks were told to curtail their support of markets as the act was deemed “too risky.”  In effect, the risk was transferred to the investing public.  Add to this mix, the usual investor who buys a stock with borrowed funds, or margin, and the downward pressure on stock prices begins in earnest.The COVID-19 virus can only be controlled by reducing the number of human interactions.  As I write this, we are midway through America’s longest enforced holiday.  Everyone who can is to stay home.  Hopefully, this will reduce the rate of spread of the virus, and (also hopefully) warm weather will cause it to hibernate until fall. This period of economic inactivity is unprecedented.  Never before have both demand and supply been depressed at the same time.  The Government is trying to revive economic activity through various legal measures.  Most have not been tried before on this scale.  The idea is to buy time for the period of inactivity to reduce the cases of infection so that our health care system does not become overloaded. So far, programs totaling $4 Trillion are being proposed.  No one is saying how this will be paid for, although the Treasury announced it would be selling more long-term debt presumably to help fund the programs.Historically, event-based market corrections are short-lived.  There is a period of time, usually, 3-9 months, when the lost ground is recovered.  This time may be different.  As people realize the precariousness of their positions, there may be an effort to create a cash cushion in the event of such an event again.  Collectively, this will reduce consumer demand.  Since about 70 percent of our GDP is consumer spending, this will have an impact going forward.Somewhat offsetting this are payments made by the government for Social Security and Medicare.  As the number of retirees increases relative to the total population, the percentage of citizens who can spend Social Security funds will go up as well. This government spending is impervious to the economic cycle and is demographically driven.Like the flu pandemic of 1918, we will get through this virus and go on from there.  The investment question is, what will the investment world look like, and how will it change.The EconomyEconomic activity is in free-fall.  With the government impaneling everyone they can into their homes, unemployment may reach 20-30 percent.Most, but not all, will return to work once this is over.  There is an estimate that as many as 30 percent of all restaurants will go out of business.  The hospitality industry, which employs about ten percent of the workforce, has been suspended.  Airlines are cutting back domestic flying by 60 percent, and international flying has been put on hold. Getting these sectors back to work will help to reduce unemployment.  The unknown is the disposition of the consumer to spend.  If spending is not robust, the recovery will take longer.InflationInflation is the factor left out of consideration at this time.  This will make it a future shock to the economy, and the market should it return. A $4 Trillion plan to revive the economy will increase the size of the national debt by about 17 percent.  Add to this the structural deficit which generates $1 Trillion per year in additional debt, and pretty soon you are talking real money.Interest RatesPanic has driven interest rates to historic lows.  Once the panic subsides, the realization that the Treasury will need to sell so much debt in short order to finance the above government programs will send interest rates higher.  Just today, the announcement that the Government was considering 50-year bonds had interest rates tracking upwards.Aside from any changes in the economy, the biggest upshot from this crisis will be to focus on the level of government debt and the deficit.  Like market liquidity, the debt doesn’t matter so long as there is someone around to purchase it at low rates.  If this assumption ceases to be valid, this could be the seed of our next calamity.The Stock MarketA stock market built on cheap and plentiful money is not on a solid foundation.  Last year, the earnings of the Standard & Poors 500 Index was almost unchanged.  It was higher valuations, in the form of higher Price-to-Earnings multiples, that caused the market to expand as it did.  Easy come easy go.No doubt, the market will recover.  Whether it goes back to its former level in a brief amount of time remains to be seen.  History tells us that the leaders of a market advance have a one in five chance of leading the next upward move.  While this market is still fluctuating heavily, there will be a time soon to get back in. As for reducing the fluctuation, both up and down, two ideas come to mind.  First, to tax security transactions. The tax amount does not have to be large (one cent per share), but the amount will be material to the hedge funds who trade in and out of shares several times a day.A second idea is to tax the income of hedge fund managers as ordinary income unless positions are held for more than a year, when it becomes taxable at capital gains rates.   Right now, hedge fund investors can get a tax break on the interest they pay to borrow stock.  The average person can deduct this too, so long as he or she has taxable income on the investments.  Hedge funds require no offsetting income, calling it carried interest.Most stocks should come back in short order.  However, this is a time to separate the wheat from the chaff.  If the environment changes, the portfolio should change with it.Warren M. Barnett, CFAMarch 23, 2020 Barnett & Company is a fee-only registered investment advisory firm registered with the Securities & Exchange Commission working with the investment and financial planning needs of individuals and organizations.  For a brochure on the company and its available services, please contact Jennifer Hairston at 423-756-0125 or This email address is being protected from spambots. You need JavaScript enabled to view it.. 
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Sacrifice the Saver: How Low Interest Rates and Fiscal Stimulus Distort Investor Options

The Federal Reserve recently issued an opinion that was interpreted by many as a signal for a rate cut at the next meeting. The current interest rate for ten-year Treasury bonds is around 2 percent per year. However, this return is high compared to other countries. In Germany, the ten-year government bond or bund, as the locals call it, currently yields a minus 0.30 percent. Therefore, every $10,000 German bund returns $9,700 in ten years. In effect, investors are paying the government to hold their money. Currently, over $10 trillion worldwide is invested in instruments that have negative interest rates. This trend, started by the European Union to stimulate their economy several years ago, has become an end in itself. Countries are fearful of inducing a recession by raising rates. However, the artificially low rates are causing distortions in themselves. Money flows to private equity firms, rather than long-term investment in capital equipment and plants. The low rates seem more beneficial to larger lenders than to consumers. Finally, low rate loans are causing people to invest in such a way as to assume that the low rates will be around forever. The justification for continuing the low, even negative interest is the presumed lack of inflation in most parts of the world. The implication is that when inflation returns, rates will rise. However, the price impact on a bond with negative interest rates to an environment where interest rates turn positive would be severe. For example, if interest rates in Germany were to go from -0.30 to 5 percent, the value of the ten-year bond would fall to less than 64 cents on the dollar. Of course, inflation depends on how you measure it. Most governments have a basket of goods for computing the inflation rate, with the prices of each good weighed and calibrated each month. The problem with this approach is that it understates inflation for services. It also ignores, for the most part, the inflation of the stock market, as well as real estate. The U.S. has benefited from these trends by sustaining a relatively high rate of interest on its debt. This rate attracts foreign money looking for a return higher than offered in their native country. The investment inflows, in turn, help to elevate the value of the dollar relative to other countries since investors have to buy dollars to make investments in the United States. Normally a strong dollar is good for imports but hurts exports. However, currently, the exchange rates between countries are in many instances being overshadowed by the imposition of tariffs, which act to make imports more expensive, while retaliatory tariffs hurt exports. The one group that loses out all around is the saver. The savers are nominally risk-averse. With returns on safe assets like government debt and certificates of deposit so low, savers are in effect being penalized. Some savers have been going to the stock market for returns, in spite of their risk dispositions not being compatible with fluctuating investments. Others are choosing riskier assets to sustain their level of cash flow. Also, the U.S. is sustaining a federal budget deficit, which will be around $1 trillion this year alone. This excess spending relative to income tax revenues acts to stimulate the economy. It creates demand that only the government bond market and printing presses can finance. Finally, the slowdown in population growth in the face of the demand for labor will become inflationary at some point, unless a lack of demand makes the economy stagnate. In essence, low interest rates and deficit spending are taking the place of population growth and exports in moving the economy forward. With everyone from the president to the Federal Reserve trying to keep the stock market moving forward, there is a sense of unreality in the current situation. It does not feel sustainable. When the tariffs against other countries hit home in the form of higher prices of imported goods and foreign markets close as retaliatory tariffs are leveled against the U.S., this situation will feel less abstract and more in need of change. In the meantime, the party goes on. Until interest rates go up, or something causes the dollar to weaken, the status quo will continue intact. In terms of the investment environment, what we have is parallel to the late 1990s when the dot-com era was ascendant. In those days, the government was running a surplus, which depressed interest rates and made the internet a mania in its own right. Like all investment manias, that one went well until it didn’t. The Economy Overall, economic data is positive, although many people are looking for evidence of the end of the economic expansion. If you look at some data long enough, you can find almost anything – especially true of today, as the trade war’s impact on the economy has been thus far less quantitative than qualitative. Many businesses are making long-term commitments based on the current assessment of the import and export environment. Given the imponderables, some businesses are deferring making any decisions at all at this time. While the general public is more focused on how much prices will go up at Walmart if tariffs are imposed, a greater impact going forward will be on technology. One conclusion of the trade war with China is the acceleration of their effort to make technology in-house, rather than depend on foreign suppliers. Doing so could have a major impact on this country’s growth. Without the profits from selling technology products to the Chinese, American companies will have to find other outlets or government subsidies to fund their research efforts. Interest Rates Given the international pressure to keep interest rates down, it would seem that only something international in scope will drive them up. When interest rates go up, it will be a period of sustained inflation. What would cause such inflation is not easy to say, but if and when it was to occur, the impact will be worldwide in scope. Early indicators of inflation expectations are the price of gold, which has now gone up to $1,400 per ounce, and bitcoins, which have also rallied. A loss of faith in government-issued currency would prove devastating, were such to happen. In some circles, the issuance of currency either in the money supply or as debt, is a precursor to inflation, as more dollars chase the same number of goods and services. Still, there are no compelling data on inflation in the U.S. financial system. Until there is, it will not be an issue. Inflation In addition to the role of inflation in the matter of interest rates, the ability of inflation to impact stock prices is less understood but is a factor in the current environment. Until perhaps a decade ago, most companies recorded revenue growth of 5-7 percent per year. About 3 percent of this was unit growth, with the balance being price increases or inflation. Today, most industries cannot raise prices without inflation. On that premise, revenue growth has slowed to unit growth, which has, in turn, been adversely impacted by the slowdown in population growth as well as the population’s aging. Unit growth is currently 1 to 2 percent overall. In contrast, relatively new industries such as streaming video, cell phones, and internet interactors have commanded very high valuations. Because these firms are new, there is no relationship between their growth rates and the overall economy. When predicting their growth, any number looks legitimate. For this to change, higher interest rates are needed, which will cause some to question valuations, and an increase in unit growth, which will come from immigration reform and exports. Both factors of unit growth and immigration are political footballs, which may not be sorted out until after the election next year, if then. Stock Market Year to date, the stock market has done well, up 15 to 18 percent, depending on the index used. The bond market is up by 5 percent. It is very unusual at this stage of the economic cycle to have both stocks and bonds go up in value. As stated previously, the assumption currently is that interest rates will stay low, the dollar will continue strong, inflation will remain under control, and people will pay up for the promise of growth faster than the overall economy. Should any of these assumptions be tested and found wanting, prices will likely be reassessed. Warren M. Barnett, CFAJune 25, 2019
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Deficits Don’t Matter, Until They Do: Parsing The Current Thinking

This year, the federal government will run up a deficit of $900 billion. The total amount of debt outstanding is about $22 trillion, which is about the same size as the entire economy. Two outstanding obligations of the federal government, Social Security and Medicare/Medicaid, are slated to run out of money in the next 10-15 years. State governments have, in many cases, similar liabilities with their state employee pension plans. Once upon a time, such data would be a cause for concern. In fact, the birth of the Tea Party in this country a decade ago was originally to publicize the deficits and advocate for their extinguishment. However, after the Tea Party coalesced around Donald Trump as its standard-bearer and he, in turn, dismissed deficits as irrelevant. The Tea Party members followed suit. The alliance has created the suspicion that the goals of the Tea Party were not so much fiscal restraint as to limit the ability of the Obama administration to respond to the greatest fiscal crisis since the Great Depression by denying them the deficit spending used by Roosevelt to address the crisis of the 1930s. Be that as it may, the deficit marches on. The tax cuts of 2017, which helped most corporations, small businesses, and the wealthy, has yet to generate offsetting revenue to pay for themselves. The non-corporate part of the tax cuts is to be slowly reversed in stages so that by 2027 rates are back to where they were before 2017. Corporate rates will be permanently reduced, or until Congress makes a change. In the meantime, government estimates of the deficit put it at over a trillion dollars per year as far as the eye can see starting in 2020. The revenue growth attained is being swamped by expenditures for Social Security and Medicare. At one time, this would have mattered. A debt clock was started in 1989 by Seymour Durst, a real estate developer. Several countries copied the idea, especially Germany, who suffered hyperinflation in the early 1920s. But beyond their progress in terms of numbers, there is little talk or concern about the federal debt. The principal reason given for the laxity about the debt is the lack of inflation. Since the implication of deficits is higher inflation, as more printed money circulates without an offsetting increase in assets, one would have expected higher inflation before now. Aside from an uptick in wages seen in the data last month, to speak of there has been no increase in inflation. While inflation in services has been far higher than inflation in goods, the overall effect is to keep the government-generated numbers fairly low. There is a school of thought that inflation, once ignited, will be difficult to contain. The primary way to contain inflation is to raise interest rates above the inflation rate. Paul Volcker stopped inflation in the early 1980s in this way. The better idea is to cut off inflation before it gets out of control. The problem is that once interest rates increase and credit is restricted, people get upset. We have already seen the President accuse the Federal Reserve of raising interest rates needlessly, which, coming from him, is an attack on the independence of the Federal Reserve to operate without political pressure. Trump has mused about firing Jerome Powell, the Fed’s Chairman, although he cannot do so. The best way to reduce the risk of increasing interest rates would be to reduce the deficit, but this would require either raising taxes or reducing spending. The only taxes under discussion to be raised by this administration are tariffs on imports. While such taxes would raise revenues, they would also be directly inflationary, increasing the price of imported goods. Citizens pay for the tariffs of the country mandating them. As for reducing spending, almost 70 percent of government expenditures are for Social Security, Medicare, or other means-tested programs. An effort to reduce these benefits would be seen as calloused at best and would be subject to ongoing legal challenges. Reducing benefits would also have direct economic consequences, as these funds usually are spent immediately. Perhaps the Tea Party should have stuck to its original mission, and not let politics deflect it from its goal of deficit reduction, assuming that was its original goal. The Economy Economic data is continuing to show signs of the disruption from the government shut down in December and January. Still, the trend is for slower real economic growth in 2019 compared to 2018, in the order of 2.3 versus 3.1 percent. The rate of growth is forecast to slow further to 1.7 percent in 2020. Contrast this to the assumptions of the President’s budget, which assumes 3.0 percent real growth each year for the next fifteen years, to result in a balanced budget by 2034. Inflation While inflation in goods and services is moderate, wage inflation is beginning to take off. A tight job market, no relief from immigration, and an aging population are combining to send wages up 3.4 percent over the same time last year. Wage inflation is important, as much of the expansion of corporate profit margins have occurred as the result of wages rising more slowly than revenues. Should this trend be reversed, companies will find themselves spending more on labor and not recovering the increase in prices. The result is a squeeze in profit margins that can only be made up by increased revenues. When the economy slows, rising revenues are harder to come by. Interest Rates The current stock market is being fueled by an expectation that the Federal Reserve will keep interest rates unchanged, which is to say below the rate of inflation. Also, the program to liquidate the government’s massive portfolio of bonds, called “quantitative tightening” will be stopped soon, so speculators will have sufficient funds to indulge in their craft of buying assets to resell at higher prices. Should either of the above assumptions be challenged, the atmosphere of the market will be sure to change, and not necessarily for the better. The Stock Market After staging a quarter that defied the naysayers who were predicting a recession last December, and citing the justification of the stock market’s direction for doing so, the market roared back in the first three months of this year to almost matching the levels of last fall. Where the market goes from here is anyone’s guess, but a long list of Initial Public Offerings (IPOs) for such companies as Uber, Lyft and any number of hot concepts is slated for release soon. In the eyes of some, this should signal a market top, as the original inside investors sell off their holdings to less knowledgeable outsiders. The result will also potentially mark the reversal of the shrinkage of stock outstanding, as new supply offsets corporate buy-backs. Even Levi Strauss, the venerable jeans maker, is public after being private for several years. Usually, when the companies become public, the stock exchange has some of its officials ring a bell. How appropriate. Meanwhile, the President has discovered a correlation between a high stock market and his popularity. Get ready for a King Canute performance, perhaps in reverse, should the stock market not deliver for him. Warren M. Barnett, CFA
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The Trade War Comes Home: The Impact Of Tariffs On Prices

World War II got off to a slow start. It officially began on September 1, 1939, with the invasion of Poland by German and Russian troops. The next advance was not until May 10, 1940, when Germany invaded Belgium, the Netherlands, and France. The eight-month interval was known by some as the “phony war,” given that there was no activity of any substance. This interval lulled some into thinking that Hitler would be satisfied with the conquest of Poland, and he was not seeking a larger involvement. History would prove such thinking wrong. This past week something similar happened to the United States’ trade war with China. Negotiations have been going on for most of the duration of the Trump administration. Last week, there were talks of additional tariffs along with the hope of some rapprochement with China. The forces of additional tariffs won out, and now billions of dollars in trade between the two countries will be taxed at 20 or 25 percent. The trade dispute reflects a long-held view of the President of the United States that a trade deficit in goods between countries amounts to some sort of weakness on the part of the country running the deficit. Thus the trade deficits of this country were the result of a failure to impose an “equalizer” in the form of a tariff to protect domestic manufacturers against unfair foreign competition. With much lower wages and living costs, goods made abroad undercut domestic competitors, and this resulted in bankruptcies and the migration of factories abroad to obtain lower wages with US ownership. In much of the rural areas and especially in the rust belt, this scenario by candidate Trump resonated. A promise to bring the jobs back from abroad and in doing so, “Make America Great Again” (MAGA) propelled him into the Oval Office. Attacking China is his effort to deliver on his campaign pledge. The trade issue resonated on other levels as well. For those worried about America’s place in the world, suppressing China seemed easier than competing with it, especially if a person believes that China does not play fair. The fear of being overtaken by another country fuels much of the xenophobia that some feel is necessary for survival. The problem is, if both sides are xenophobic, who is left to express reason? Economists who advocate unhindered trade speak of comparative advantage. If one country can make textiles more cheaply, let them. Their wealth generation will make them buyers of wine, technology, and software from affluent countries. Both sides benefit because they are producing for others what they do best. The current plan to place 20 or 25 percent tariffs on almost all trade between China and the United States negates the idea of comparative advantage. The Chinese will pay more for goods made in America, and Americans will pay more for goods imported from China. Up until now, non-consumer goods had most of the imposed tariffs, or intermediate goods, which are used to build something else. Because of this, tariffs have been slight to non-existent for most consumers. That is about to change. First, understand that a tariff is a tax paid by the consumer of the importing country. The Chinese government does not pay tariffs. American and Chinese consumers pay them. For this reason, when introduced into the mainstream, they are considered inflationary. Especially hard hit are fungible goods like farm products, which any competing country can provide. One idea is that by slapping tariffs on Chinese goods, the US will encourage cheaper imports from other countries. However, the data so far shows that the output from competing countries winds up priced as if also carrying the tariff, with the difference pocketed by the non-Chinese manufacturer. In a similar vein, domestic producers will raise their prices by the amount of the tariffs to fatten profits, secure in the knowledge that so long as tariffs exist that the excess profit will flow to them since they no longer have Chinese competition breathing down their necks. Do tariffs lead to higher employment? Not really. While there has been a revival of some steel mills here, companies who have to pay 25 percent more for expensive steel suddenly realize they cannot compete with non-Chinese imports and lay people off. Job gains and losses net out to close to zero. Finally, are tariffs inflationary? Yes, very much so. Especially after the decision this week to impose 20 or 25 percent fees on a broader sweep of goods, the price increases imposed by tariffs will be impossible to avoid. Like World War II, the beginning was slow, but the pace going forward will be much faster. Like any war, there will be a lot of collateral damage. Historians will tell us if it was worth it. The Economy It is probably a source of great frustration to the President that he cannot call for an election now. With low unemployment, low inflation, and high numbers of job creation, Trump would seem to have economic data for another four years. Alas, the elections are not for another 18 months. In that time, almost anything can happen, and almost anything will. Economic data is positive, but there is always the problem of the implication of the budget deficits, tariffs, immigration, etc. Whether the President can skate by on these issues until November 2020 is anyone’s guess. Economic forecasts now call for a slowing but still growing economy for the balance of the year. Until 2020 becomes more focused, we will stay with the trend of slower but steady growth. Interest Rates Interest rates continue to stay low, in the process fueling everything from stock prices to private equity takeovers. An obsession with letting the inflation rate dictate the prevailing interest rate has resulted in very low rates for some time, to say nothing of a valuation bubble in certain financial assets. The prevailing talk is for the Federal Reserve actually to cut interest rates sometime this year, a view embraced by the administration’s spokespeople, who want cheap and abundant money to be flowing come election time next year. The Federal Reserve is not on board for such a cut, making it problematic. Inflation With the trade war now open and raging, the currently subdued inflation is kindling searching for a match. A cursory stroll through a Walmart or Costco will confirm how much the US imports from China. An excellent preview of the inflationary effect of tariffs comes from the washing machine industry. With 25 percent duties put on imported washers and dryers early on, unit volume of laundry appliances is down five percent compared to last year, while prices are up seven percent. Stock Market The May 13th decline of some 2.4 percent in stock prices underscores the attention investors give the world outside our borders. Already the President, who yesterday said that hiking tariffs were a foregone conclusion, is now saying that he has not decided to raise tariffs on some $325 billion in Chinese imports from America. As a world leader, you can only change your mind so many times before people begin to lose faith in your ability to mean what you say. Trump continues to insist that China will pay for the tariffs. The reality is that the American people will pay in the form of higher prices for any number of items they buy. They will pay more for the imports of other countries as well as the output of domestic producers, both of whom will have less competition. Whether cooler heads will prevail is not known. What is known is that the country cannot continue to live in a state of perpetual crisis, especially of our own making. If the future cannot become more stable, stock prices will suffer. Markets are incredibly adaptable, but they need a given state in which to adapt. We are not getting that. Warren M, Barnett, CFA May 14, 2019
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2019 Forecast: It May Be Later Than You Think

After the sharp decline in December and equal recovery in January, investors can be forgiven for believing that the financial markets are back to normal after a slight hiccup. While there are parts of the market and economy that are cruising along, the reality is more complex. There is a feeling among some of the more exotic investments that time is not on their side. To wit, last week the price of bitcoins dropped to a level that was less than the cost of producing them. Also, at the World Economic Forum in Davos, Switzerland this past week, where the wealthiest converge to reassure the public and themselves that all is right with the world, there was the aggressive promotion of firms like Uber, Lyft, and software companies of several stripes to prime the market for their public stock offerings, probably sooner rather than later. This stood in contrast to a year ago when wealthy investors were reluctant to go public when the perceived value of these enterprises was skyrocketing. I once knew an investor who believed that a sharp increase in the number of initial public offerings was the sign of a market top. Conversely, the low number of public offerings was symptomatic of a market bottom. The idea behind the strategy was one of supply and demand. New issues increased the supply of stock, while fewer shares of stock offered led to higher prices, given the long-term demand for shares. The concept was formed long before the days of stock buy-backs, private equity, and other forces that weigh on one side of the equation or the other. Still, the concept bears observing, especially as more companies come to market. Remember that for each buyer there is a seller. When several companies come to market at once, it may be a sign that insiders see either lower levels of growth or greater competition. Or, the owners believe that with higher interest rates to pay in the future, it may be better to sell than to share profits with the lenders. This brings up a second observation. According to earnings forecast, some companies will generate less profit in 2020 than in the last twelve months. Earnings declines over the next two years seem focused on the industries like retail banking, where in some cases the cost of funds is rising faster than the ability to charge for the same. This scenario has the effect of squeezing interest income. Other industries that are forecast to feel the heat are some real estate enterprises, retail, restaurants, and the like. Judging from the earnings estimates published thus far, it seems that cost pressures may make economic growth more difficult to translate into profit growth. This is especially true of labor-intensive companies. Demographic trends are pretty much set, and any respite from immigration reform is not on the horizon. While the federal government shutdown has been canceled, at least for the next three weeks, it gives Congress a window of time to iron out contentious issues regarding immigration and national security (issues not resolved for 60 years), there are other dates to note in the near future aside from the threat of another shutdown February 15. March 1st is the “hard deadline” in our discussions with China regarding tariffs. Without an agreement by that date, the U.S. is to impose a 25 percent tariff on all imports from China. Logically, one would expect the Chinese to impose the same tariff on goods imported from the United States. There are two bones of contention. First is the imbalance in trade that China has offered to rectify by 2026. The second concerns the theft of intellectual property. Outside of court, this is difficult to prove. It is not clear if the U.S. administration is insisting on compensation for past acts of intellectual property theft, guarantees against future theft, or what. It is true that China has insisted on access to a company’s intellectual property as a condition for setting up a manufacturing facility in China, usually as a joint venture with a Chinese firm. However, acceptance of the terms was voluntary by the company. It was considered a cost of access that was worth paying. If you wanted a presence in the Chinese market, you had to pay the price. Stated terms going in can hardly be considered intellectual theft. Also on March 1st or thereabouts, the federal debt ceiling will need to be raised, providing another legislative free-for-all. Then, March 29th is the deadline for the United Kingdom to decide whether or not to exit the European Union. Along with the unforeseen, this should be a lively spring. The Economy In truth, there is no reliable way to know how the economy is doing. All the departments of the U.S. governments associated with data collection have been shut down for the past five weeks. Without data, any assessment of the economy is a guess. With the government reopening soon, we will hopefully have data in short order on what has transpired in December, January, and February. Most assessments have been fairly benign, but with a total of two million people unpaid or out of work (800,000 civil servants and an estimated 1.6 million contract workers), the effects are perhaps more substantial than realized. Estimates by economists have called for up to 0.5 percent cut from this year’s GDP number. On the other hand, the large numbers of people retiring may make the next downturn easier on workers who stay, meaning there will be the need for fewer layoffs with so many voluntary retirements. Inflation Inflation is higher than stated. The government indexes on inflation, delayed with all other economic data, are too oriented to goods and not enough to services. Also, unemployment rates are a function of those willing to work. The data is not being tabulated, but it appears that unless we liberalize immigration, wage pressures will result in higher inflation. There are simply not enough workers to go around. Interest Rates There is a sense that the Federal Reserve may have been more lax on interest rates while the shutdown was in session, to avoid a financial problem when the government was not up and running. If this is true, funds should become a bit tighter in the coming weeks. With the passage of some time, data will tell us what we need to know. The Stock Market The market, in general, is coping with the slowdown in the economy. Parts of the market will have a harder time coping than others. Specifically, there seems to be a sense that higher interest rates and more restricted credit will bear down on some high-flying investment concepts. If a couple of new stock offerings go badly, the market could take on a different tone than the present. Warren M. Barnett, CFA January 28, 2019
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Market Inefficiencies Redux: How Falling Prices Do Not Indicate Future Value

On the surface, it is irrational for people to clamor to buy stocks at their highs, and avoid them at their lows: same stocks, same companies, different prices. The change in investor’s expectations can only understand this irrationality. When prices are rising, the expectation is that prices will continue to rise. When they fall, investors expect them to fall further. Logic would dictate that neither position can be true over time. The value of the stock market will not rise to infinity, or fall to zero. Thus what is needed in these times is the ability to think independent of the crowd. Warren Buffett said as much in his 2017 letter to the shareholders of his firm, Berkshire Hathaway. In that letter he quoted excerpts from the poem If–, by Rudyard Kipling:     If you can keep your head when all about you are losing theirs…     If you can wait and not be tired by waiting…     If you can think—and not make thoughts your aim…     If you can trust yourself when all men doubt you…     Yours is the earth and everything that’s in it. Academics like to claim that the market is efficient. It is nothing of the sort. If it were efficient, it would not fluctuate as much as it does. Are fluctuations a reason not to invest? Not if your time horizon exceeds the periods of excesses, positive and negative. Much is made in market lore about buying at the bottom and selling at the top. Such stories forget that the top and bottom are set only in retrospect. When the market makes a top or bottom, nobody rings a bell. With so much emphasis on the short-term, perhaps value can come from looking at the longer-term. Focusing on industries, the larger airlines, for example, there is little doubt that they will continue to garner their share of domestic and international travel. Oil prices have gone down and come back at least six times in the past decade. No doubt they will do so again. Affluent retirees will demand better lifestyles and healthcare. Someone will profit from providing it. Demography is destiny if you research it right. Government is a source of anxiety, but it always is for someone. However, historically from a market perspective, a divided government (when one party holds one branch and the other party the other) is shown to be the best environment for stocks. As for issues like the deficits, they will be resolved during some crisis, which is really the only way to change a system of checks and balances. Someone will have to come in and reset the scale. Is the world in bad shape? Compared to when? There are now more people living in middle-class surroundings than ever before on the planet. Not all countries are democracies, but perhaps not all should be. It takes a certain evangelical perspective to decide that the rest of the world should be just like us. Maybe they should decide what they need to be, and be just that. There is all manner of human suffering in the world. With modern technology, we can witness it in a way that was not previously available. However, awareness and action are two different issues. Unless the United States is going to become the world’s police, there is a limit as to what we can do. What we need to make sure of is that we are not aiding and abetting the policies of others that are contrary to our nature, by providing the arms or resources to carrying out suffering. Finally, the immigration issue is not going to go away. Politicians on both sides of the aisle have used it as a way to raise campaign contributions and rally their base. It is time for us to decide if we need the workers, how to enlist them, and whether and how to grant them citizenship, and under what terms. With labor shortages everywhere, the matter of not permitting immigrants unless they hold advanced degrees is preposterous on its face. How many individuals with a PhD wants to cut the grass, or clean the swimming pools? The current labor market is tight enough for all levels of employment. Make the workers register so that they are paid in a manner that collects taxes for the government. Give them the rights that accrue with being a worker in this country, and arrest employers that pay them less or provide less safe conditions for employment, or do not pay the government employment taxes. Have a set time with a workers visa (which would renew with continued employment), and provide a pathway to citizenship within a certain period. One step to providing more workers has come from the changes to the status of former prisoners in the United States. Hopefully, with greater opportunities after incarceration, and fewer automatic sentences dictated by law, this group will be able to find itself back in the mainstream of society. For the young who found themselves rounded up for victimless crimes like marijuana use, this will hopefully be a new lease on life. The Economy Economic activity is slowing, but not contracting, as expected after the sugar high of the tax cuts in 2017 that mainly went to corporations. Greater economic growth going forward will depend on domestic worker growth, net exports, and government demand. With a trillion dollar deficit projected, government growth is limited. Exports are hostage to the trade war and its resolution. Domestic workers will depend on the above penal and immigration reforms.  There is some talk of trying to stimulate the economy in 2019 by creating an “infrastructure bank” that would lend funds to states to improve roads and bridges and collect interest and principal on the loans. This arrangement may mean more toll roads, which is better than no roads at all. Inflation Inflation continues under the radar as it shows up more in services than in goods. With the tightness of the labor markets, it seems a matter of time for higher wages, as more people retire and fewer enter the workforce. Immigration and penal reform will help address this, to an extent yet seen. Interest Rates Interest rates are slated to move higher. Recently, the head of the Federal Reserve Jerome Powell said that while the rate of increases may slow in 2019, the shrinking of the availability of credit in the form of the redemption of bonds held by the Treasury is on “autopilot.” Therefore, the amount of credit taken out of the economy will be in the neighborhood of $150 billion per quarter for some time. While this will mean higher interest rates, it will also mean more income on bond investments. Often overlooked is the extent to which the low interest rates impacted the elderly, and as a result, forced them into the stock market. As interest rates return to their normal range of 4-6 percent, look to see more retirement funds diverted to bonds from the stock market. The Stock Market The stock market exists in a state of confusion. There are some owners of index funds that have no compunction dumping them, as they have no real knowledge of what they own. The last of the market sectors to decline; utilities, consumer staples, and healthcare, all have gone south in the past ten days. With almost the entire market down, a case can be made for a rally of some caliber in the near future. Longer term, competition from higher interest rates and slower earnings growth for most sectors will make it more of a market of stocks, as opposed to a stock market. Warren M. Barnett, CFA December 20, 2018
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Living Through the First Correction In Ten Years

On a typical day, about one half of one percent of all shares of stock in this country changes hands. Depending on whether there are more sellers than buyers or more buyers than sellers, the result projects the value of the other 99.5 percent of stocks that did not trade that day. For the past seven weeks, we have witnessed more sellers than buyers, overall. The market’s decline, which has wiped out most of the gains of 2018, has occurred in an environment of positive economic data, low inflation, and meddling economic growth, which is about average for an economy of our size. Some people believe the stock market’s decline is a harbinger of an economic recession, although the relationship between market declines and economic direction is no better than a coin toss. Half the time, markets predict economic declines and half the time they do not. Sometimes you just have more sellers than buyers. Is there anything that stands out about this correction? A couple of things. First is the accelerating demise of hedge funds. There were, at the peak, 10,000 hedge funds in this country. People tried to capture inefficient returns until there were none left. Since economic opportunity is finite, but the amount of money chasing signs of growth is almost infinite, it would stand to reason that returns would be driven down to zero. Some hedge funds are closing their doors. Since this decline has begun, at least eight hedge funds of $1 billion or more in assets have announced they are liquidating. The culprit is the success of the concept. Hedge funds, who use increasingly esoteric strategies to try to earn excess returns, are less able to beat the market when they are the market. Hedge fund strategies range from momentum to smart beta. None of the strategies work when there is no one on the other side of the trade. As investors bailed out of hedge funds, the redemptions triggered significant selling, which caused hedge funds to underperform even more. The golden age of hedge fund investing was generally up to 2006. While many hedge fund operators presented themselves to the world as investment wunderkinds, in reality, much of the return was the result of competing with the exchanges who were still using humans to execute trades. Given the computing power obtained by the hedge funds, competing against human floor traders was like shooting fish in a barrel. It was as lop-sided as the outbreak of World War II when the German mechanized infantry went up against the Polish Calvary, which then still used horses. After the great real estate bust of 2007-2008, hedge funds as a group began to underperform their corresponding indexes. Once everyone, including the exchanges, had computers, the advantage of the speed of execution diminished. Added to that was the fact that as funds grew in size, there became fewer investment opportunities in a size that would supposedly allow for liquidity. In this case “liquidity” refers to the ability to get out of a position without moving the market. One popular strategy of hedge funds was to use momentum, which is the rate of change in the price of a stock relative to an average, to find investment “winners”. If a stock was going up more than the overall market, hedge funds crowed in, making the stock go up more, and vice versa. Hedge funds, for the most part, invest for the short-term. They generated billions in commissions, which made them popular with brokers. However, as time went on, investors grew disgruntled with returns at best no better than the market, for a far higher fee. This fall, some investors began to exercise their right to cash in their hedge fund investments. As the number of redemptions rose, the momentum stocks went into reverse, as the funds sold them to raise cash. As few were buying compared to the number selling, prices began to buckle. Caught up in all of this are the owners of index funds. Most people who buy index funds believe they are getting diversification, and that such diversification reduces risk. The problem is that, at its peak, almost a quarter of all index funds for the Standard & Poor’s 500 Index invested in five stocks: Facebook, Apple, Amazon, Netflix, and Google. As the liquidating hedge funds sold these stocks, indices took a hit. If five stocks made up 25 percent of the fund’s value, then 495 stocks account for the 75 percent balance. While such diversification has reduced risk compared to some hedge funds which have been wiped out, it has not this year generated positive returns, which some investors have come to expect. From a historical perspective, the correction is long overdue. Markets go both ways, which creates an opportunity for those who have courage and convictions when others do not. Markets also go up over time, in tandem with the economy overall. The challenge is to determine how companies are doing and invest in them. Hedge funds, with their algorithms, were trying to find opportunities that may exist only for a second. Investors have a time horizon far longer than that. When will the correction end? That is hard to say. Hedge fund selling should be abating by year-end. Whether owners of mutual funds and ETFs will sell next is anyone’s guess. The bottom will only be seen in retrospect when it happens. Thankfully, this is occurring during a time of economic prosperity, rather than a financial meltdown like 2008. When markets are this nervous, people tend to focus on the risk to the downside. When markets are at peaks, people look at the potential for further upside. Sort of the opposite should be done. The Economy Economic activity is continuing to look good. Employment gains are solid, and retail sales are doing well for the holiday season. Certain sectors like farming and energy, both of which have sustained collateral damage from the administration’s policies of a trade war and encouraging higher international oil production respectively, have seen some weakness. Hopefully neither is a permanent state of affairs. Next year, however, is expected to be a year of slower economic growth than 2018. The lack of a tax cut, lower export demand, and a lack of follow through by businesses to invest in capital goods with their tax savings, will all conspire to lower earnings growth to 8-10 percent, or about half the rate of 2018. Inflation Inflation’s latest damper has come in the form of lower oil prices. The 30 percent decline from the peak earlier this year has led to lower inflation rates, potentially even to the point of impacting the cost of living adjustments for 2020. Other commodities have also fallen, including lumber and grains. Steel and aluminum, in contrast, are still up 18 percent since the tariffs on imports were imposed. Steel, in particular, is needed for the infrastructure program that is slated to be announced early next year. Interest Rates Interest rates are still expected to rise again in 2018 but may get a reprieve in 2019. The Federal Reserve has noted that the rest of the world has not done as well as the U.S. in maintaining economic growth. This may be laying the groundwork for a hiatus from further increases until the rest of the world catches up to the U.S. regarding economic growth. The Stock Market While not in a panic, investors feel like 2018 was taken away from them. How this sentiment plays out with additional selling from here is anyone’s guess. At some point, the market will find a bottom and will advance from there. As stated before, a not-yet-named sector will lead the way. It could be airlines, infrastructure, or any number of other groups. Warren M. Barnett, CFA November 27, 2018 Tags: Perspectives
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Changing Of The Guard: How Market Corrections Lead To New Favorites Going Forward

Regarding the overall market averages, October undid most of the progress for stocks for the calendar year. Regarding the stocks that have led the advance over the past five years, the declines were more significant. For Facebook, Apple, Amazon, Netflix, and Google (collectively referred to as the FAANG stocks for their initials), losses have been as much as 25 percent. Of this group, only Apple has anything that approaches an average market valuation of around 16x earnings. The rest are valued far higher than the market overall. Growth stock investing tends to focus on rising revenues on the expectation that earnings will eventually manifest themselves. A true growth stock is usually in a nascent industry. Analyzing their potential demand and profit tends to be more art than science since there is no context to correlate their demand relative to the larger economy. For this reason, any earnings forecast, no matter how far-fetched can be acceptable. This is how growth stocks take off. In this cycle, growth stocks are aided by the reluctance of policymakers to raise interest rates back to a level that cash can earn a legitimate return. Because the return on “safe” investments like savings accounts and certificate of deposits has been minuscule, even risk-averse people have been forced to look for returns in the form of appreciation. Since most growth stocks by definition have revenue growth higher than the overall economy, they become the vehicle of choice when the other component of return (cash flow) falters. Now the environment is changing. Interest rates are going up, which provides competition from more passive investments. Credit is tighter, as the Federal Reserve sells off its investment portfolio and takes funds out of circulation in the process. Inflation, which in an advanced economy is more in services, is advancing faster than the official rate, which tends to focus on goods. There is some concern about the economy, but more concern for the stability of the future. In an election year, politicians advance the concept of a hostile world that only they can defend us against, and only if re-elected. If the events of October and prior portend to a correction in market leadership, then at some point new investment concepts should unfold. While it is a bit early to say just what they will be, the implication is that they will not be leaders of the last advance. Research has shown that the leaders of one market cycle have less than a one in twenty chance of leading the next market upswing. This is why often successful growth stock investing consists of jumping off the train before it leaves the tracks, then finding the new concept to jump onto. One group of investors in growth stocks, who are probably oblivious of their participation, is the investors in index funds. At one point, the FAANG stocks described above counted for over a quarter of the value of the Standard and Poor’s 500 Index. As these stocks fade and others take their place, expect erratic behavior out of the indexes and the corresponding funds. Into the vacuum left by the stories of growth are value stocks. In contrast to growth securities, value stocks do have earnings and dividends. They may, by their legacy, be unable to paint the picture of Jack and the beanstalk growth that their newer brethren do, but they do not hit a wall and leave no skid marks either. As volatility becomes a more pervasive thing, knowing that a company makes real money, pays real dividends, and has real assets give investors the anchor they need to withstand the crosswinds. The philosophical difference between growth and value investing is that value tries to know the bottom, with the upside unknown or undefined. Growth tends to look for the upside, with the downside undefined. In a choppy market, the two styles can give the appearance of being similar. When liquidity dries up, neither growth nor value strategies tend to work. Over time, the knowledge that value has a base becomes reassuring, until the next Pied Piper growth story. Then we are off to the races with the growth concept. Based on what has transpired, it would appear that things will recover towards year end. After that, what happens is a function of fear and hope. This is true of all financial markets. The Economy Economic news is good, which is a wonder why Republicans do not mention it. Productivity is up; wages are finally rising, the unemployment rate is at a 49-year low. Only the recent stock market reversal is a skunk at the garden party, especially for a president who campaigned on the idea that the recent record stock market rally was his validation. While there are many worries, from tariffs to relations with trading partners, it seems the default path is for a somewhat stronger economy going into 2019. However, without the sugar high of the tax cuts enacted in 2018, expect slower growth in profits and the economy going forward. Interest Rates Like almost every politician before him, Trump has criticized the Federal Reserve for raising interest rates. Politicians do not like high interest rates, as they can impair an economy in a way the politician gets blamed. The posturing aside, interest rates will keep going up. By historical standards, interest rates are still low, which enriches the speculator and investor at the expense of the saver. There needs to be a better balance here. Inflation Inflation is a matter of whom you ask. Purchasers of services contend inflation is strong, while purchasers of goods marvel at stable prices. That separation in the inflation rate between goods and services will disappear once the tariffs take hold, which unfortunately for most families will be right before the Christmas shopping season. The tariffs, enacted to bring more manufacturing to the U.S., will at least in the short-run lead to higher prices for imports from China and other targeted importers. A classic case of being careful what you wish for. The Stock Market Stocks have slid in October, taking most of the gains for the year with them. Once the elections are over, we hopefully can reunite the country behind one set of values, which is a different hope from being united behind one political party. November and December are the months that investors begin looking at 2019 earnings estimates. To the extent that markets thrive on hope, this tends to be the elixir for markets going forward. Warren M. Barnett, CFA November 1, 2018
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