Market Commentary - July 2017

“To think that the new economy is over is like somebody in London in 1830 saying the entire industrial revolution is over because some textile manufacturers went broke.”
- Alvin Toffler; Author of Future Shock; 1928-2016

This note will put the new economy in context, highlight one amazing decade and discuss whether the altered contour is cyclical or secular – with different investment implications to each.  

Economic Evolution

6,500 years of Mesolithic and Neolithic periods to introduce tribes and division of labor. Another 4,000 years to establish city states, laws, and coins. Before the Industrial Age, starting in 1769, approximately two out of every three Europeans worked in agriculture. ⁽¹⁾  Fast forward a mere 200 years to confront the fastest, most powerful economic storm ever unleashed, the “New Economy”. Let’s examine those key events that occurred over 10 years beginning in 1988 which shaped today’s economic landscape.  

Laverne and Shirley Era  

Gross Domestic Product (GDP) grew between 3-4% through the 1980’s. ⁽²⁾ Ford, GM and Chrysler controlled 70% of the U.S. automobile market. ⁽³⁾ Approximately 17.5 million Americans were employed in manufacturing. ⁽⁴⁾ Contextually, that represented 7.6% of the 225 million people living in the U.S. in 1980. ⁽⁵⁾

Inflation averaged 6.6% per year between 1973 and 1989. ⁽⁶⁾  Oil bounced between $35 and $42 per barrel. ⁽⁷⁾

Interest rates, as measured by the 10-Year Treasury Bond, allowed investors to stay ahead of inflation with a yield of 8%. ⁽⁸⁾  

For investors, these were glory years. Strong economic growth, plenty of middle-class jobs and gradually decreasing interest rates stirred together, to produce exceptional investment results for the decade. (Stocks ~17% and bonds ~12% per year) ⁽⁹⁾

From 1989 – 1999; Chronologically

• 1989; Fall of Berlin Wall. Tiananmen Square. Opened the floodgates for global trade. Increased the supply of capable labor, making outsourcing feasible and pressuring wages.
    
• 1991; Introduction of the World Wide Web. Outsourcing reduced the cost of goods sold. The internet enabled global broadcasting of those prices so that consumers could adjust their buying habits accordingly.  
  
  
• 1991; Reduced labor force. In 1991 women in the U.S. averaged 2.1 births compared to 1.8 today. ⁽¹⁰⁾ Legal immigration to the U.S. was 1.8 million in 1991 compared to 1.3 million in 2015. ⁽¹¹⁾   Both changes served to reduce the growth of the U.S. labor force.
  
  
• 1994; Amazon started selling books. The move to online retailing threatens not just individual companies, but entire industries. Amazon ratings can drive buyers to specific products based on performance and customer ratings, potentially weakening brand strength and the ability to capture premium pricing. Downward pressure on pricing.  

• 1994; Smartphone introduced. ⁽¹²⁾  Mobility allowed consumers to further price compare. Traditional media outlets such as newspapers, magazines and radio losing relevance. Constant connection spawns the “sharing economy” of Uber and VRBO. More supply equals lower prices.
  
  
• 1997; Fracking technology took a quantum leap enabling the economically feasible extraction of gas from shale. Toyota introduced Prius. Oil, at $42 per barrel today, compared to approximately $38 in 1980, means that oil prices are significantly cheaper today when adjusted for inflation. More downward pressure on pricing. ⁽¹³⁾

• 1998; Google was born. The ultimate in sharing, transcending barriers of geography and language. Paul McCarthy once said, “If you want it, here it is, come and get it”. ⁽¹⁴⁾

All done in 10 years.   

The Big Bang Theory

If the 80’s were Laverne and Shirley, today must be The Big Bang Theory.  It also happens to represent a great metaphor for the current state of the economy after the electrifying 10 years described above.  

• Slow economic growth.  Ruchir Sharma, Global Strategist for Morgan Stanley, believes that 2% growth in the labor force is necessary to drive the 3% average growth in GDP that we became accustomed to between 1960 and 1990. ⁽¹⁵⁾   Yet, lower fertility and immigration (see 1991) have combined with outsourcing and robotics to reduce the growth of the labor force, well below Sharma’s targets, as seen in the graph below. ⁽¹⁶⁾

Emblematic of these larger trends in outsourcing and global competition, American automobile manufacturers now control about 45% of the U.S. market. ⁽¹⁷⁾  Manufacturing employs 12 million workers today, or 3.7% of the 325 million Americans, compared to 7.6% in the 80’s. ⁽¹⁸⁾

Fewer workers support the retiring Baby Boomers, straining both Social Security and Medicare, inflaming budget deficits and diminishing fiscal flexibility.  Savings rates continue to rise to compensate for slow wage growth and low bond yields. ⁽¹⁹⁾

• Low interest rates.  With less money available for Fiscal stimulus, the governments of most developed nations leaned heavily on monetary policy in the wake of the 2008 Great Recession.  The 10-Year Treasury Bond finished the quarter at 2.3%, compared to the 8% available in the 80’s.

• Low inflation.  Why not?  Wages are constrained by the mobility of production and technology.  The cost of capital is cheap (low interest rate). The cost of energy, adjusted for inflation, is lower today than it was in the 80’s (both supply and demand influences).  Because of the sharing economy, middlemen are being eliminated, removing both jobs and cost components. Personal Consumption Expenditures, a key barometer for the Federal Reserve, fell to 1.4% last month, the lowest level in months. ⁽²⁰⁾

New Normal?

Mohamed A. El-Erian, then head of Pimco, is generally credited with having coined the phrase “New Normal” for the economic conditions that prevailed after the 2008 Great Recession. The name implies a condition more structural than cyclical -- perhaps akin to the glaciers having permanently created lakes, waterfalls and gorges. While admittedly difficult to call, we want to highlight the two potential paths:

Cyclical:  The strongest argument supporting the cyclical theory comes from the Federal Reserve Board. They have lifted interest rates twice in the past six months and, despite the recent low reading for inflation, look optimistically across the chasm for more traditional levels of economic growth. Earlier we referenced that two of every three jobs were in agriculture. Today, approximately 1.5% of US employment is tied to agriculture, suggesting that the economy can, over time, adapt. ⁽²¹⁾

If the Fed’s assumptions come to fruition, we can expect interest rates to normalize. Historically, the 10-Year Treasury Note has provided a yield of 1.5% - 2.0% above inflation, suggesting that yields could reach 3.5 – 4.0%. ⁽²²⁾ This would represent a significant jump from current levels, hurting those holders of longer term bonds and presenting a viable alternative to yield seekers such as retired baby boomers. This would most likely siphon some money out of the stock market, especially the low volatility, higher yielding sectors such as telecommunications and utilities that currently act as bond surrogates.   

Structural:  Rebuttal to the Fed comments comes from the notoriously smart bond market. The 10-Year Treasury was yielding 2.6% on December 16, 2016, a day after the Fed increased short-term rates by .25%. On June 14, 2017, the Fed again raised rates and this time announced a shrinking of their balance sheet (super aggressive monetary policy post 2008). The bond market response?  The 10-Year Treasury is down to 2.3% at the end of the quarter. If the bond market believed that economic growth would accelerate, it would seek a higher yield for tying up money for 10 years, instead of a lower yield. With the S&P 500 trading at 18 times 2017 projected earnings, a relatively lofty level, and largely supported by low interest rates, this is not a trivial issue. ⁽²³⁾

How to Navigate

We continue to hold cash and see it as the ultimate tool for flexibility. We refuse to extend the maturity of bonds out to the 10 years allowed for in your Investment Policy Statement, reflecting more of a risk/reward assessment than a timing call. The difference between 2-year notes and 10-year Notes is only .85% per year, low by historical standards and not, for us, worth the extended time risk. ⁽²⁴⁾

The financial markets have responded to uncertainty surrounding economic growth, inflation and interest rates by taking a shorter-term view. Momentum investors ignore fundamentals and focus instead on price movement in both directions. Though the S&P 500 was up more than 8% through the first half of the year, an index of momentum stocks was up 18%. ⁽²⁵⁾ Fundamental investors strategically aim to buy low and sell high. Momentum investors are more than happy to buy high with aspirations of selling even higher. This cycle can continue until the epiphany occurs that the Emperor might not have new clothes – think dotcom stocks at the end of 1999. Then, fundamentals reassert and the cycle reverses itself to the downside.  

The self-fulfilling cycle of momentum investing is being partially fueled from the tidal wave of money pouring into mutual funds and Exchange Traded Funds with passive strategies. Remember from our past notes that the S&P 500 is market capitalization weighted so the better a stock performs, the more the index must buy. This and any other process that unhinges fundamentals from prices presents opportunities for us such as: 

• We buy a stock based on fundamentals. Momentum investors “discover” the stock and ride it up in price. You may see us sell great stocks of great companies because of excessive valuation, such as Idexx Labs.
• The market generalizes that Amazon will make retail stocks like buggy whips so they aggressively sell the entire sector. We can pick through the litter and find terrific values such as Nordstrom.
• Fast money left Europe because of political uncertainties that ultimately failed to materialize. Our consistent exposure to foreign based investments has quietly enhanced returns for the past year.

Momentum investors tend to trade heavily and the window on opportunities may not stay open for long, so expect to see a few more transactions than usual as these opportunities arise.  

Toffler once said, “No serious futurist deals in prediction. These are left for television oracles and newspaper astrologers.”  We relate and will, instead, deploy discipline to purchase unloved securities and sell those reflecting irrational exuberance.

P.S.  

On June 9, 2017 the Department of Labor's (DOL) Fiduciary Rule went into effect. The years of lobbying and fees paid by the brokerage industry eventually lost out to the common good. It’s a shame that Wall St. brokers needed legal intervention to put their clients’ interests first. Although the conflicts replete in the industry make our “fee only” story easier to tell, all financial advisers have had to bear a burden of skepticism due to the industry’s bad apples.  

1. Federal Reserve Bank of St. Louis; fred.stlousfed.org
2. Bureau of Economic Analysis; BEA.GOV
3. New York Times; December 7, 1989.
4. Economic Policy Institute; The Manufacturing Footprint and Importance of U.S. Manufacturing Jobs; Robert E Scott; January 22, 2015.
5. WWW.Census.gov
6. Raw data from Federal Reserve Bank of Minneapolis. Calculations done by WCF.
7. U.S. Energy Administration; WWW.eia.gov
8. WWW.Treasury.gov
9. Raw data from Chase Global Data. Calculations done by WCF.
10. Data.worldbank.org
11. “Frequently Requested Statistics on Immigrants and Immigration in the United States”. Migration Policy Institute. March 8, 2017.
12. Simon Personal was introduced by Bell South with technology from IBM. Bloomberg; June 29, 2012.
13. Raw data from Federal Reserve Bank of Minneapolis. Calculations done by WCF.
14. McCarthy wrote the song in 1969. First performed by Badfinger in 1970.
15. “The Demographics of Stagnation”, Foreign Affairs Magazine; February 15, 2016 Ruchir Sharma; Global Strategist for Morgan Stanley”.
16. Monthly Labor Review; “Labor Force Projections to 2024. www.bls.gov
17. Edmunds.com. Compared to 70% in the 1980s.
18. Federal Reserve Bank of St. Louis. FRED.Stlouisfed.org
19. Barron’s; June 23, 2017. The savings rate in the U.S. has moved from less than 2% to over 5% since 2005.
20. Wall St. Journal; June 30, 2017.
21. Federal Reserve Bank of St. Louis. FRED.Stlouisfed.org
22. Between 1960 and 2010 the average 10-Year Treasury Yield was 2.6% higher than inflation WWW.Treasury.Gov for yields. Chase Global Data for inflation. Calculations done by WCF.
23. Earnings estimates from Yardeni Research; July 3, 2017.
24. US Treasury.gov.
25. iShares US Momentum up 18.02% through 6/30/17.