Tuesday, February 07, 2017

The Winter’s Tale

"A sad tale's best for winter: I have one of sprites and goblins.”

{"The Winter’s Tale” by William Shakespear, Act 2, scene 1, lines 25-26}

I have always thought of the end of January as the rump of winter.  Now I find out that in the vast realm of fake science {right up there I guess with fake news} is the concept of “Blue Monday”, a day supposedly calculated to be the third Monday of January as the worst day of the year.  Whether we define this time as a set period or a single day, there is no doubt by mid-January; winter can certainly weigh on the soul.  That is especially true for those of us who reside in the northern half of the United States as we are usually beset by our worst winter weather by now.  Chicago usually finds this time with sub-zero temperatures and often snow.  This year we have been largely spared the artic blasts and tundra but the sun seems to have gone south on vacation and I think we’ve seen sunshine about three days in the past three weeks.  Instead, the days have been dark and damp, perhaps reflecting the nation’s mood as Donald Trump is sworn in as our 45th President.  For the millions who did not vote for him, his ascendancy to the nation’s top office has been viewed in almost apocalyptic terms.  For many of his supporters, it is not hard to imagine some anxiety as even they might wonder what they purchased with their vote.  Yet whatever our individual views on the election we must now deal with the new reality.  My mandate is to view the new administration through the investment matrix and that is what I intend to do in a question and answer format.

Why did the stock market rally after the election?

Markets rallied after the election in a way that was opposite of the nearly 10% decline that occurred at the beginning of 2016.  Then investors decided that the economic projections were too optimistic. Stocks rallied in November because political uncertainty had been removed from the system.  Whether investors supported President Trump or not, you then had an idea of the general direction of economic policy over the next few years.  Benjamin Graham, the famous value investor once said of the markets in the short run it is a voting machine but in the long run it is a weighing machine.  In this instance it seems to me the market both voted and weighed in favor of what it perceives as strategies likely to be employed by the new administration that favors domestic growth and pro-business policies.  After our results came in investors assumed their views on the future had been too negative given the new reality and markets rallied.

How did the markets do last year?

The S&P 500 returned 9.5% plus dividends and the Nasdaq Composite returned 7.5%.* Overseas, developed markets returned 1.5% and emerging markets rebounded from a disastrous 2015 with a return in excess of 11%. A diversified portfolio of assets returned 8.3% last year.**    It is easy now to forget how volatile markets were at the beginning of 2016.  Last year’s 10% market decline in January was the worst start to a year since 1930.  US markets advanced in the spring on better economic numbers and an uptick in the price of oil.  Globally, markets surprised investors by rallying after Great Britain voted to leave the European Union despite an initial sell-off after the results were announced.  The same pattern repeated itself after Mr. Trump was elected President in November.  Markets were initially down by better than 3% on news of the Trump victory but quickly righted themselves to post a substantial rally by year-end.  The S&P 500 gained nearly 5% after the election, almost half of its return came between November 9th and December 13th. Last year is a wonderful argument for staying the course in one’s investment plan.  There were plenty of times last year when pundits and commentators offered well thought out reasons to get out of the markets.  Investors that listened to that advice were likely regretting it by year-end. 

So what comes next?

Stocks have rallied on what is believed to be the new economic environment.  Now comes the hard part for the new Administration of actually making policy into law.  Investors will want progress from President Trump on economic policy, job growth, immigration reform, tax reform, and cutting government red tape.  Progress on those fronts could mean the optimism we have seen in the past few months could continue.  On the other hand an early stumble in implementing these policies or a wavering from these goals could lead to market turmoil at some point.  Early on, the new Administration seems the most vulnerable to a major foreign policy crisis.  We will have to watch how President Trump deals with Russia, China, Mexico and the Middle East as well as our nervous allies.  Assuming we avoid foreign policy mistakes and also see some progression on the economic front then stocks have the potential for positive performance in 2017. 

We are currently using an earnings range of $130-133 with a mid-point of $131.50 on the S&P 500 for 2017. The index currently trades with a price to earnings ratio between 17.50 and 18 by that analysis.  At these levels the earnings yield on the S&P 500 is still north of 5.5% and the dividend yield of the S&P 500 carries a yield slightly better than 2%.  Valuations may seem elevated by historical standards but seem more reasonable with longer term interest rates such as the US government 10-year treasury bond still below 3%.  I use a system called the Cone of Probability {COP} when calculating a possible range for the S&P 500 in a given period.  Current inputs give us a COP between 1,950 and 2,500 with a midpoint of 2,400.  That is approximately a 6% price appreciation potential to the midpoint from current writing.  Add on a 2% dividend and domestic US equities have the potential to see a total return for 2017 between 6-9%.  For sake of comparison, last year I used an initial COP of 1,700 to 2,150 on the S&P 500.  The index traded as low as 1,807 in February, put in a year high of 2278 on December 13th and closed the year at 2,239.

The Cone of Probability is our current probabilistic assessment of the trading range within which we think stocks have the potential to trade during a described time period.  Our analysis is based on many factors.  Some of these include: Earnings estimates and whether those estimates are rising or falling, dividend yield, earnings yield and the current yield on the US 10-year Treasury bond. The COP is used solely for analytical purposes.  It will fluctuate with market conditions and changes to our data inputs.  Equity prices can and have traded outside of these ranges.  The data supplied here is for informational use only.  There should be no expectation that this price range will be accurate and there are no guarantees that this information is correct.

What worries you?

Here are some of the areas where I think investors should be paying attention.  First, while I believe stocks have the potential for appreciation, valuations are not cheap.  An event that causes investor into risk off mode could leave stocks with more of a decline than many have become accustomed to.  I understand investors hate volatility.  However, it is the price investors pay for liquidity.  It is the reset mechanism that often caps the financial excesses that sometimes can lead to larger market declines. Investors should expect some volatility and should accept that sometimes prices will correct.   Last year we began the year with nearly a 10% correction in the markets.  Historical volatility suggests that correction usually fall between 10-20% with the historical average around 14% decline.  It’s been awhile since we’ve seen a decline of that magnitude.  There was about a 14% decline in 2015 but then you have to go all the way back to 2011 to find a similar event.  A 15% decline from current prices would take us to around 1,900 on the S&P.

The first event that I think could lead to that higher volatility would be a faster increase in interest rates versus investors expectations.  Paradoxically this could also be a positive as it could make fixed income investments more attractive for portfolios, but it would also be competition for stocks.  The 2nd would be a foreign crisis or some other unexpected event. The 3rd could be a stumbling of the Trump economic agenda. 

Regarding the 2nd issue if somebody asked me to look for an unforeseen event that could be a problem over the next few years I would keep a watch on Mexico.  Mexico relies heavily on four sources of income as it struggles for economic growth and each is in trouble.  One of its major resources is oil.  But Mexico’s oil production has fallen precipitously in the past few years due to declining reserves and inadequate infrastructure investment.  Lower prices for oil also haven’t helped. Another source of revenue coming into Mexico has been from the sale of illegal drugs into the rest of North America.   While the majority of these profits go to the cartels some of that money gets dispersed into Mexico’s economy.  However, the other side of that is that the Mexican Government has waged war against the cartels since 2006 to staggering costs.  Through 2013 it is estimated that Mexico has spent over $172 billion dollars in combating the trade and an estimated 100,000 Mexicans have lost their lives to the violence.  It is anybody’s guess what happens to these cartels as drugs, especially marijuana are decriminalized in the United States.

Another major source of revenue for Mexico is tourism.  Unsurprisingly the fear of violence has seen the number of tourists and their desired foreign cash reserves into the country decline.  Finally, perhaps the major source of foreign cash coming into the country comes from the Mexican immigrant communities in the United States and to a lesser extent in Canada.  Not only has this been a major source of money but immigration has also been a pressure relief valve on the Mexican economy.  Mexico simply cannot create enough jobs for its population.  Now, demand for immigrant labor in the United States is declining and has been doing so for years.  Illegal immigration into the US is therefore down as well.  All of that is before President Trump builds his wall.  Now maybe Mexico will make it through these problems but it is the one foreign area I think bears watching that perhaps others are not regarding at this time. 

Finally markets may become more volatile if investors become concerned whether President Trump can get a large portion of his economic agenda passed.  It is early in the new Administration so this will likely be months in the making.  For those wanting a truer picture of the Trump Administration’s plans as it goes along I would caution you to pay less attention to the regular press or pundits.  Trump spent nearly two years making them look bad and they have a vested interest in seeing his presidency fail.  Business oriented media like the Wall Street Journal, Investors, Business Daily or the Economist may be a better judge of his economic policies than even CNBC, the New York Times or the Washington Post.  However, the best arbiter of his policies will likely be the markets.

A Few Final Thoughts

There are always worries when investing and often it’s the event that nobody pays attention to that harms us the most.  That being said the current weight of the evidence seems to suggest that the underlying foundations for a positive market environment are in place.  There will be volatility this year as there always is but we have an administration that at its onset has a pro-growth agenda.  If they can execute the majority of that plan then it has the potential to be good for our economy and ultimately good for the markets.  As such I think a major change has occurred where buyers will be found when volatility returns.  In that scenario investors will likely be rewarded for picking good solid ETFs that have appreciation potential as well as pay dividends and using cash reserves to pick at bargains.

Very truly yours,

Christopher R. English

Christopher R. English is the President and founder of Lumen Capital Management, LLC.-a Registered Investment Advisor regulated by the State of Illinois. A copy of our ADV Part II is available upon request. We manage portfolios for investors and also manage a private investment partnership. The information contained here is taken from sources deemed reliable but cannot be guaranteed. Mr. English may, from time to time, write about stocks or other assets in which he or other family members has an investment. In such cases appropriate discloser is made. Lumen Capital Management, LLC provides investment advice or recommendations only for its clients. As such the information contained herein is designed solely for the clients or contacts of Lumen Capital Management, LLC and is not meant to be considered general investment advice.  Mr. English may be reached at Lumencapital@hotmail.com.

Long ETFs related to the S&P 500 in client and personal accounts.


**Asset class returns taken for this report can be found at JP Morgan  “Guide to the Markets”, published quarterly J.P. Morgan Asset Management.com.
Go here if you want to see some of the astounding statistics for Mexico’s war on drugs and the narcotics trade into the United States..


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