Author: subir

Q3 letter: The market can remain irrational…

Q3 letter: The market can remain irrational…

We trust you’ve all had a pleasant summer. As we head into autumn, the question on every investor’s mind seems to be when the longest running bull market in US history will end. For several quarters, we’ve advocated caution based on our view that equity valuations continue to be unreasonably high. We have, however, always kept Keynes’ adage in mind, that “The market can remain irrational longer than you can remain solvent”. Keynes learned this valuable lesson through his own experience trading currencies and investing on behalf of the King’s College endowment from 1921-1946. Many things have changed in the investment world since Keynes coined that phrase, but economic cycles have not. And just as it was during Keynes’ time, all bull markets eventually come to an end (sometimes abruptly) and usually with a recession.

When assessing the health of the economy, there are several indicators investors and economists monitor to gauge whether the business cycle is approaching a recession. Let’s consider them one by one:

  • Consumer Confidence Index: This index published by The Conference Board measures economic optimism of US consumers via their spending/savings activities.  The Consumer Confidence Index dropped 9 points to 125 in September, with both consumers and businesses indicating conditions were not as good as they were earlier in the year, however levels are still fairly high. The same organization publishes a “CEO Confidence index” which also dropped 9 points to the lowest level in our decade long expansion, suggesting the corporate C-suite is showing more trepidation than consumers at the moment.
  • Stock Prices: are considered a leading indicator of economic activity since valuations are based on future earnings. The S&P 500 reached an all time high in August (3007 points), we are now approx 4-5% below that high.
  • Purchasing Managers Index: The Institute for Supply Management publishes an aggregate measure of the US manufacturing sector. This index dropped to 47.8% in September (from 49.1%). Any reading below 50 signals a contraction. A key measure of exports dropped to the lowest level (41%) seen in a decade. The corresponding measure for the services sector (the NMI) stands at 52.6%.
  • Durable and manufactured goods orders: The US Census Bureau reported that durable goods orders increased by 0.2% in August, while shipments and inventories of durable goods rose marginally. New orders for manufactured goods dropped by 0.1% in August, shipments and inventories rose marginally. 
  • Housing starts: The Census Bureau also reported that building permits rose 7.7% in August (seasonally adjusted). New residential construction is at the highest level it has been since 2007 (but well below the highs of 2005).  Some of this can be attributed to falling interest rates lowering the cost of capital.
  • Weekly Hours: This measure estimates the number of paid hours worked by the hourly workforce. This indicator bottomed out at 33.7 hours in 2009, it reached a high of 34.6 hours in 2016. It is now close to that high, at 34.4.
  • Global Trade: The WTO measures trade in goods and services across the world. Its most recent report indicates global trade in both goods and services has weakened in all regions this year. The softness is largely driven by unresolved trade disputes. The Global PMI stands at 47.5, which is the lowest level since 2012. 

Taken in aggregate, consumer confidence (the most forward looking measure) and the PMI indicate some softness in the economy. Global trade activity is weakening, which is also a negative sign. Other indicators signal low to moderate growth. The services sector appears to be growing, with exports and manufacturing showing no growth or mild contraction.

Interest Rates are also considered a leading indicator of economic activity. Lending for long periods of time carries greater risks than short term lending, and investors generally demand higher rates to lend for longer periods. When long term interest rates are higher than short-term rates, the “yield/rate curve” is considered to be normal. When long-term interest rates fall below short-term rates, it implies that bond investors believe rates will be lower in the medium-long term (i.e. the Fed will lower rates in response to a worsening economy). This is often called an “inverted yield curve”.

Many participants watch the “10 Yr – Fed Funds spread” to gauge the shape of the curve. This measures the difference between 10 Year interest rates and overnight Fed funds rates. When the overnight (1 day) interest rate is above the 10 Year rate, the spread is negative. The graph below shows a history of this rate spread. Every recession since 1960 (see shaded columns) has been preceded by a negative spread, i.e. an inverted yield curve.

Unemployment rates are the strongest single indicator that a recession has begun. Unemployment claims tend to rise almost exactly as the economy contracts.  Businesses know it’s expensive to hire and train staff, so managers often wait to reduce headcount until they’re certain markets are shrinking. When large numbers of workers are laid off, they change their consumption behavior, spending less. This change in behavior can become “contagious” as neighbors and former colleagues of the unemployed also retrench, reducing their own consumption in the face of economic uncertainty. This feedback loop in turn deepens the recession.

Overall, we believe there are significant risks of a recession ahead. If the unemployment rate rises, and the stock market slides further, that should be seen as a confirmation that the economy has begun contracting. We would then recommend very defensive positioning in client portfolios.

Our current recommendation to investors is to maintain caution and vigilance, rebalancing portfolios to be defensive and be prepared to act if conditions deteriorate further. 


Subir Grewal, CFA, CFP                                                                     Louis Berger

Q2 letter: A sugar high

Q2 letter: A sugar high


We hope you’ve had a good start to the summer.

The interest rate outlook has changed considerably since the beginning of the year. Investors entered  2019 with an expectation the Fed was likely to continue raising rates over the course of the year. However, recent comments from Fed officials have made rate hikes far less likely. There seem to be three factors influencing  this sudden shift in Fed policy. The first is gathering signs of a softening economic activity across the world (the IMF estimates countries representing 70% of the global economy will slowdown in 2019). The second is continuing uncertainty surrounding the US’s trade policies. The last is the political pressure being placed on the Fed, mainly expressed in the form of public statements and tweets from the president as we head into a presidential election next year. Rate cuts at this juncture would prolong the rally and the current economic expansion, aiding the administration’s prospects in 2020. Though other administrations have tried to coax the Fed, they’ve done so more quietly. We don’t know whether Fed officials will find Trump’s more public approach tougher to ignore. The bond market itself seems to be anticipating cuts, the yield curve is “inverted”, i.e. near-term rates are lower than those further out. This has historically been an accurate indicator of an upcoming recession.

As we begin the third quarter, the stock market remains close to all time highs, with the S&P 500 hovering at just under 3000 points. Despite some turbulence, stocks continue to be led by the technology sector, which is now over 26% of the S&P 500’s market capitalization. That factor has only been higher once, during the peak of the tech boom when it crested over 30%. The Nasdaq, which contains a large number of technology companies, is above 8000, an all-time high. However, there are some indications that the technology rise has run its course. This year has seen a steady spate of large technology IPOs for companies that have grown privately over the past ten years. This includes: Lyft, Uber, Slack and Pinterest among others.  Historically, such a spate of stock sales has been an indication that professional tech venture capital investors see the current price environment as a high-watermark, and an ideal time to exit investments that have grown in value for several years.

In general, the economy remains at very high levels of capacity utilization. Unemployment remains at a multi-decade low and wages rose swiftly in the past two quarters. The manufacturing and services sector remain at high levels, but growth in new orders has slowed. The purchasing managers indices for both manufacturing and services fell below 51 (a level of 50 indicates no growth). Anecdotal reports suggest the weakness is at least partly due to trade uncertainties. Consumer confidence also remains high, despite a sharp drop in May. 

Our general view remains that investors should exercise caution. We continue to recommend a defensive allocation with greater exposure to high quality bonds and lower exposure to risk assets.  


Subir Grewal, CFA, CFP                                                                     Louis Berger

Q1 letter: A Song of Spring

Q1 letter: A Song of Spring

Dear Friends,

Spring is in the air. Subir’s younger daughter won’t step outside without checking to see what plants and trees have flowered. It is a special joy to be reminded of the resilience of life and the cycle of the seasons.

Back in the more quotidian world of markets, Q1 saw US equities rally sharply, recovering from the lows seen in December. Stocks remain below the highs of last summer. Part of this can be explained as a relief rally after a tough Q4. Year-end consumer spending was not as bad as feared. The government shutdown did eventually end and everyone apart from contractors was paid for time lost. Of course, time is a non-renewable resource and several weeks of human effort were lost.

A more influential factor spurring the rebound was the Federal Reserve reversing policy in early January, telegraphing a pause in interest rate hikes. The Fed appears to have been spooked by a confluence of factors including: the shutdown, Brexit, the Q4 correction, deterioration in hiring, and a softening of real-estate prices in several markets. Going into the year-end, we’d expected two rate hikes in 2019. It is now far less likely that this will happen. In our view, this weakens the Fed’s ability to act if we do enter another recession.

There is some speculation that the Fed’s back-tracking was a response to pressure from the White House. If that were the case, it would be a cause for concern. It’s clear to all concerned that the president would like to see an accommodating, low-interest rate policy heading into the 2020 election cycle. In that respect, this White House is no different from any other first-term administration. However, the nature of the President’s statements is somewhat unprecedented. The Fed is largely independent of the government and such attacks do present another test to our institutions. However, most market participants have been ignoring rhetoric coming out of the White House. As long as the Fed governors don’t let this affect policy, and chairman Powell can brush off the president’s frequent bromides, the White House’s statements are likely to have no impact on the market.

Looking beyond our shores, we still see an unsettled environment. The United Kingdom continues to lurch towards a break with the EU, without any firm plan in place. In our view, the UK’s exit from the EU system will have a significant economic impact, but it is unlikely to be extreme. We do not ascribe to the doomsday Brexit scenarios.

Further afield in Asia, we still see unsettled questions around trade with China impacting real economic activity. Companies continue to shift production out of China and into other South Asian countries. We believe these trade spats portend a major shift away from the post-war order. For over 70 years, we have seen free, global trade as the reigning orthodoxy for relations between nations. This is now being replaced by a more mercantilist stance in both the EU and US. The US response to the rise of Huawei and other 5G Chinese manufacturers underscores this. In Japan, the details of Charles Ghosn’s arrest suggest that Japanese officials moved out of fear a top-3 Japanese automaker would be absorbed into Renault.

If we are honest with ourselves, we will admit that various European countries, and Japan have always had a mercantilist trade policy supporting national champions. The US less so for most of the 20th century (outside of energy policy). That is clearly no longer the case, at least under this administration.

There are several reasons for this shift, the most significant is the clear rise of China under a semi-managed system. The development of an information-based services economy and the disruption of manufacturing industries through outsourcing is also part of the explanation. These momentous changes taken together have brought into question the 20th century orthodoxy of free-trade in goods/services as the only route to prosperity. Many in developed countries challenge these assumptions by pointing to declining living standards among the general population. They can also point to examples like China, which continues to keep much of its domestic economy closed and props up state-owned national champions. All this creates a more unpredictable investment climate, where we now have to consider the political links of major companies alongside their purely commercial prospects.

From an investment perspective, we continue to advise investors to maintain cautious allocations. Though markets have recovered from their December lows, the past 15 months have seen increased volatility and we expect that to continue going forward. As we enter the spring, we will remain watchful for long-term opportunities that arise from any further correction.


Subir Grewal, CFA, CFP Louis Berger

2019 Investment Themes: Bear Market Blues

2019 Investment Themes: Bear Market Blues

Dear Friends,

We hope you’ve had a restful holiday season with family and a pleasant start to the New Year.

The fourth quarter of 2018 saw steep declines in US stocks, with certain indices entering bear markets (20% below their highs). Amid these moves, the Federal Reserve followed through on broadly held expectations and raised its benchmark Fed Funds rate to 2.5%. Taking a longer view, it’s clear the post 2000 era has been unusual. From 1962 to 2000, the Federal Reserve had never lowered rates below 2.5%. Since 2000, rates have remained below 2.5% for 15 of the last 18 years. Extremely low interest rates were made feasible by the near disappearance of inflationary pressure in the US. Prices for most manufactured goods have been kept low for over two decades as manufacturing was outsourced and large Asian populations were integrated into global industrial production. This multi-decade trend has allowed US and European central banks keep interest rates at historic lows without triggering inflation. Absent a dramatic reversal in global trade policy, we do believe this long-term trend will continue. In the near term, the Fed chairman has signaled two more interest rate hikes are expected in 2019 which would take the benchmark rate to 3%. We believe the Fed is more likely than not to follow through on these hikes, for two reasons:

1. Q4 saw unprecedented pressure from the White House on the Federal Reserve to avoid a rate hike. This included rumors that the president had sought to dismiss chairman Powell in an attempt to influence interest policy. The White House does not have the authority to dismiss the chairman except for cause, and we believe the Fed will be keen to demonstrate its independence by following through on its previously broadcast intentions.
2. Fed governors are well aware that recessionary risks are high in 2019. If the Fed Funds peaked at 3%, the Fed would have more room to respond to a downturn using rate cuts alone. We believe Fed governors would prefer to use interest rates to respond to the next recession, rather than a revival of the unprecedented Quantitative Easing (QE) program put in place in 2008.

Normalized rates, trade disputes, a faltering Chinese economy, and concerns about asset valuations in a long-running US bull market combined to deliver a very volatile stock market in December. Stepping back to get a wider perspective, we are nearly ten years into an exceptionally long bull market. Several risks to economic growth materialized over 2018. Central banks globally have pulled back from the exceptional liquidity programs adopted after the financial crisis. These factors combine to create a less forgiving investment environment and makes a so-called soft-landing less likely. In our view, the underlying risks to the US and global economy advocate for continued caution on the part of investors. As always, long-term opportunities will present themselves in choppy markets and we intend to capitalize on them when they do.

We have enclosed our 2019 investment themes as well as a review of our 2018 themes. We hope to have an opportunity to discuss them with you in the near future.


Subir Grewal, CFA, CFP                                                Louis Berger

2019 Economic Themes: Return of the Bear

  1. Bear Market Comes out of Hibernation.  2018 saw a major speed bump in the nearly 10 year global bull market run in stocks. We contend this reversal gains steam this year as stocks globally will finish 2019 in firmly negative territory.  Trade wars, rising interest rates, inflated asset valuations, and a general slowdown in economic activity will contribute to  a “risk-off” environment where investors prefer protection over speculation.
  2. Peak Interest Rates.  In December of 2015, after seven years of 0% interest rate policy, the Federal Reserve shifted course and slowly began to raise interest rates in 0.25% increments. At the start of 2019, the effective target rate stands at 2.25%-2.50%. While the Fed has signaled a continuation of rate hikes this year and into 2020, we think rates will peak in 2019 and the Fed will pause before potentially cutting rates if/when a recession materializes.  We do not think the Fed will raise past 3% in this year.
  3. Unemployment Rises.  2018 saw the US unemployment rate reach a 49-year low of 3.7%. The US economy has come a long way since unemployment peaked at 10% in October 2009.  That said, this expansion cycle looks due for a reversal and we expect the unemployment rate will climb back over 4% in 2019.
  4. Investors Want Value.  Since 2009, US growth stocks have outperformed US value stocks in seven of those ten years (including three of the last four). We believe value will outperform growth this year as economic expansion slows and investors shift investment capital into more defensive sectors.
  1. The Unwinnable War.  Despite rhetoric from president Trump that trade wars are “easy to win” and a March 1 deadline to resolve the US/China trade dispute, we see no quick and easy resolution to this fiasco. We see 2019 ending with some measure of tariffs still in place, continued global hostility towards the Trump administration and ongoing damage to the US reputation and economy.
  2. Real Estate Reckoning.   2018 saw residential real estate prices finally eclipse the peak reached before the credit crisis. The S&P/Case-Shiller 20 City Composite Home Price index peaked in April 2006 and didn’t reach a bottom until March 2012.  Since then, it has seen a nearly 7 year uninterrupted run-up of higher prices.  We think this streak comes to an end in 2019 and the index will finish the year lower.
  3. Oil Prices Flounder.  After peaking at $86.07 on 10/4/18, Brent Crude oil prices tanked in Q4, finishing the year at $51.49 per barrel. While there may be a short term bounce in prices to start the year, we believe Brent Crude will dip below $50 per barrel and finish the year under that level as global trade slows and energy consumption slackens.
  4. High Times for the Cannabis Industry. In recent years, marijuana has made a steady push into the mainstream as several US states and a few countries have passed legislation to legalize recreational consumption.  A nascent industry has emerged to service this growing demand.  Many of these companies are small, regional operators, but recently, larger and better-financed corporations have entered the space with many becoming publicly traded entities.  While the road has been rocky and the sector has seen large price swings, we think this is an industry poised for long term growth.  We expect 2019 will bring more legislation to expand the recreational market and more investments from multinational conglomerates (2018 saw Altria and Constellation Brands invest in the space).  We expect publicly traded marijuana stocks will outperform consumer discretionary stocks in 2019.
  5. China Stumbles. Over the course of 2018, we saw several worrying signs that the Chinese economy is slowing. Property prices, which have propped up all other assets for years have slowed, and there are numerous reports that several non-bank lenders have halted redemptions. The trade war with the US has also been a major drag on the economy.  2018 was a terrible year for Chinese stocks — the S&P China Composite index returned -27.82% — and while some investors expect a bounce-back year, we  believe 2019 will continue to be a flat to negative market for Chinese equities. The Shanghai Composite remains around 2,500. This is less than half the 5,178 level reached in 2015, which was lower than its all time high of 5,800 in 2007.
  6. Battery Power.  A long-term trend we are highlighting in our thinking for 2019 is the growth of plug-in electric vehicles. Roughly 2 million four wheel electric vehicles were sold in 2018. US sales of EVs represented over 1% of total vehicle sales. In California, the largest passenger vehicle market, EV were 4% of all vehicles sold spurred by tax incentives and emissions targets. When we include plug-in hybrid electric vehicles, EV sales account for over 7% of all vehicle sales in California. These figures portend a long-term shift in the transportation industry, of the same degree as driverless cars. 10 years from now, we expect 25% of the world’s vehicle fleet to be battery powered. Over the long-term, this implies a very difficult environment for the oil and gas industry. We expect EV sales to continue to grow in 2019, and global liquid fuels growth to be below 1.3%.
Review of 2018 Investment Themes

Review of 2018 Investment Themes

2018 was an uneven year for our market predictions.   We were right on six calls and wrong on four calls.  While we were right about the general market direction, a few of our sector specific calls were off the mark.

  1. Slow But Steady Rate Rise: We expect the Fed to maintain the normalization plan and continue tightening rates in 2018 with the Fed Funds rate ending the year in the 2%-2.5% rangeThe Fed started 2018 with a target interest rate of 1.25%-1.50%, raised rates four times by 0.25% to finish the year with a target rate of 2.25%-2.50%.  This was precisely in the range we expected.
  2. Year of the Donkey: We expect the mid-year election of 2018 to mark a sharp reversal for Republicans, who currently control all three branches of federal governmentThe 2018 midterm elections resulted in a sharp rebuke to the Republican agenda.  Democrats won the House popular vote by a whopping 8.6% and had a net gain of 40 House seats, taking back control of the House of Representatives.  They also had a net gain of seven governorships and six state legislative chambers.
  3. The Bull Runs Out of Steam: We expect 2018 to be a difficult year for equities markets given the extremely high levels attained over the past two yearsAfter a fast start in January, 2018 turned into a down year globally for stocks.  In the US, large caps fared best as the S&P 500 index finished the year at -4.38%.  Mid caps were hit harder as the S&P MidCap 400 index returned -11.08%.  Small Cap value stocks brought up the rear in the US as the S&P 600 Value index returned -12.64%.  International stocks lagged the US as the FTSE All World (Ex-US) index returned -14.13%.
  4. Rise of the Machines: As we did in 2017, we expect AI/Automation stocks to outperform consumer discretionary stocks.  While we strongly believe Artificial Intelligence and Automation companies will be integral to the global economy in years to come, 2018 saw stocks in this sector hit a speed bump as investors sold off more speculative technology names.  The Global Robotics and Automation index finished the year at -20.92% while the S&P Global Consumer Discretionary index returned -6.24%.
  5. International Beats Domestic: We expect international stocks, especially European markets, to outperform the US in 2018.  We were flat out wrong on this call.  International stocks fared worse than US stocks in 2018, with European stocks performing particularly poorly.  The S&P 500 index posted a return of -4.38%,  the FTSE All World (Ex-US) index returned -14.13% while the MSCI EMU index returned -16.90%.
  6. Bitcoin Bust: Bitcoin prices themselves are in a speculative bubble which we expect will reset in 2018. Bitcoin’s meteroic rise in 2017 saw a sharp reversal in 2018 as speculators fled en masse.  Bitcoin opened 2018 at $13,444.88 per coin, but finished the year at $3,880.15 per coin, a drop of 73.70%.
  7. Renewables Redux:  2017 saw renewable energy YieldCos outperform conventional fossil-fuel based electric utilities.  We expect this trend to continue through 2018.  While we strongly believe in the long term prospects of renewable power, YieldCo stocks trailed conventional utilities for a variety of reasons: energy prices fell (because of higher up-front costs, YieldCos tend to be more attractive when energy prices are high) and a flight to safety from investors (conventional utilities are a popular safe haven in times of market volatility).  The INDXX Global YieldCo index finished the year -4.98% while the S&P Global 1200 Utilities Sector index was up 1.69%.
  8. Organics Go Mainstream: We think organic food stocks will outperform conventional food stocks this year.  2018 was a tough year for packaged food stocks across the board.  That said, organic companies performed notably worse than conventional food companies.  The MSCI World Food Products index returned -12.99% while the Solactive Organic Food index returned -26.61%.
  9. New Dawn of Space Race: 2018 will see a number of commercial space ventures mark milestones, including manned-flight into low-earth orbit and potentially a lunar orbital space tourism mission.   2018 saw several space related milestones. The highest profile was a successful test launch for SpaceX’s Falcon Heavy rocket, which placed a car in a helio-centric orbit that takes it past Mars. Virgin Galactic completed testing a craft designed for sub-orbital space tourism flights. The most interesting project is the Japanese Hayabusa2 mission. Hayabusa2 successfully rendezvoused with the asteroid Ryugu and placed multiple rovers on the surface. The spacecraft will return a sample from the asteroid to Earth. This mission provides a viable template for future space based mining endeavors. These technological advances will take a decade or more to reach industrial scale, but once they do we believe they will significantly alter the nature of the mining industry.
  10. Net Neutrality Fallout:  Telecommunications firms have risen in the past month as a result of this ruling, but we believe the medium and longer term prognosis is less rosy, with the prospect of new entrants and even more consumer dissatisfaction.  2018 did see a backlash against the major telecom companies and the net neutrality ruling certainly didn’t help to reverse the cord-cutting trend.  Telecoms underperformed the broader market in 2018 as the S&P 500 Telecom Services Index returned -7.20% while the S&P 500 index returned -4.38%.
The signal among the noise

The signal among the noise


As we approach the end of an eventful 2018, there continues to be a steady torrent of major news stories dropping daily. From CEOs tweeting about taking their companies private, to escalating global trade wars, to bitter battles on Capitol Hill, the financial markets have had a lot to digest. Though the news can seem overwhelming at times, we believe investors should remain focused on the issues that matter for their investment portfolios: valuations, interest rates, economic conditions, and global trade. Each of these factors are at levels that indicate a richly valued stock market in the final stages of a historically long expansion with potential for major risk ahead. Let’s walk through each of them one-by-one.

Interest Rates. As expected, the Federal Reserve raised interest rates in the third quarter and the Fed Funds rate now stands at 2.25%. The 10 Yr Treasury rate is almost at 3.25%, which is the highest it’s been since 2010. It’s likely the Fed will raise rates again by 0.25% in December and continue to raise rates at a similar pace (quarterly) in 2019. While rates remain on the lower end historically, rising rates will continue to take a chunk out of corporate profits as companies raising funds for projects in the debt markets are now paying higher rates than they have in years. The tax cut passed by Congress last year has provided a bit of a tailwind for corporate profits, but this boon will likely be offset by the costs associated with higher interest rates, especially for sectors that depend on high levels of debt.

Global Trade. Despite a major change in trade policy (tariffs), trade levels remain high. That said, there are several looming disputes (US-China, US-Europe) that may cause continued dislocation. We are beginning to see American companies modify their supply chains in response to tariffs. Though, in the long run, this will lead to the growth of manufacturing in new markets and new sources for intermediate and finished goods, in the shorter run this is likely to lead to some dislocation. History shows us that tariffs are almost always a net negative on economic output (as open trade is closed off) and we see no reason why the current tariff war will result in anything other than economic slowdown. If the results of the “new NAFTA” is any indication, the tariff wars will not bring increased economic prosperity to the US, but rather, hurt industries dependent on foreign trade while damaging relations with our trade partners/allies and eroding their trust.

Valuations. Stock valuations remain at cyclical highs. The S&P 500 is trading at 25 times historical earnings, which is about 50% higher than the historic average. When we look at cyclically adjusted measures of earnings, these are at even higher levels. Yale professor Robert Shiller’s Cyclically Adjusted PE ratio (which uses the past ten years of earnings as a denominator to account for the business cycle) is currently over 33. The only other time it has been higher than 30 was in 1929, on the eve of the great depression, and in 1999-2001 during the tech boom. This measure has been above 30 for most of 2017 and 2018. Can this continue? It certainly can, but if we use history as a guide, economic expansion can end quickly, rendering current valuations as especially lofty in hindsight.

Economic Conditions. Despite the concerns mentioned above, economic conditions in the US continue to be quite strong, with consumer confidence levels high and the unemployment rate low. Inflation is relatively tame and average hourly wages are finally rising. However, debt levels — corporate, government and consumer — are all at precariously high levels. If interest rates rise, trade wars persist and valuations remain elevated, we could see these conditions deteriorate.

In addition to these factors, there is a potential major market-moving event on the horizon: the mid-term elections on November 6th. Mid-term elections tend to be a referendum on the White House and ruling party in Congress. Given the president’s low approval ratings, we believe Democrats are likely to re-take the House. We think they have an outside chance at winning back the Senate. This is far less likely because there are fewer Republican seats up for election, and because small, low-population inland states get as many senators as large coastal ones. We think a House controlled by Democrats will lead to meaningful investigations of political corruption in the Trump administration. All indicators suggest this is a target-rich environment for such investigations. If the White House decides to work with Democrats, as they indicated they might in 2017, we could see a curtailment of tariffs and a wide-ranging infrastructure bill. Given the highly partisan political environment, however, compromise seems less likely and gridlock the norm.

How will markets respond? It’s difficult to predict, but if we see a Democrat controlled house, the Congressional agenda of the past two years (deregulation, protectionist trade policy, tax breaks and loosening of environmental regulations) will likely end. Investors in sectors like conventional energy and materials/mining will see this as a negative. Sectors like renewable energy and industries dependent on trade, like technology, are likely to view it as a positive development.

We continue to recommend balanced investment portfolios and a reduction of exposure to risk assets that may be vulnerable in a market correction.


Subir Grewal, CFA, CFP    Louis Berger

Keeping an eye on what matters for the economy, Trade.

Keeping an eye on what matters for the economy, Trade.

Dear Friends,

Over the past year and a half, trying to absorb news has felt a bit like drinking water from a fire hose. Like many of you, we have steadily become more concerned and simultaneously more accustomed to the chaos being created by the current US administration. While the actions of our government have deviated from the values of the American people in the past, this disconnect is especially evident today. The government’s high disapproval ratings reinforce the fact that its actions represent a minority of American society. A large majority of Americans are not beguiled by the administration’s base appeals to fear.

Amid all the animosity directed at weaker members of our society, the administration has also undertaken ill-considered actions on trade that we believe will impact investors.

In many industrial fields, US protections for workers and the environment outpace those in developing parts of the world. This, coupled with our relative wealth, creates a situation where set-up costs tend to be higher in the US than they are in less wealthy nations. The international trade norms which have been adopted by much of the world over the past several decades acknowledge this fact. They establish basic labor and environmental protection standards which most nations adhere to. The expectation is that as industries in other countries mature, they face natural pressures to improve labor and environment practices. We can see this dynamic in effect in China, India and much of the developing world as a more assertive labor force organizes itself and citizens demand safer, cleaner, healthier environments. Previous US administrations have largely stuck with this bargain and helped cement it. This administration’s response is markedly different. It has worked relentlessly to demolish protections for workers and the environment, engaging in a race to the bottom. Such an effort will have a long-term impact on our human and ecological capital.

US workers, citizens and enterprises have legitimate concerns about our trade policies. Much of what our country exports is ethereal: movies, software, music, designs and technology are simple to reproduce if the original source is available. American technology companies fend off numerous attempts each day to steal valuable designs or content. Some of these attempts are successful. In several cases, the perpetrators and beneficiaries of such thefts are politically connected businesses.

Prior administrations have worked to slow down and deter such anti-competitive trade practices, opting for targeted action that sought to limit the impact on other industries. The current administration has repeatedly shown a penchant for using a sledgehammer when a scalpel is more appropriate, and this matter is no different. It has embarked on a series of wide-ranging punitive tariffs on a range of goods, from a number of different countries, including China and close allies like the EU and Canada. These countries have begun to respond, slapping tariffs on American exports.

As the cycle of tit-for-tat increases in import duties gathers steam, markets have begun to wobble. Global trade and supply chains rely on orders placed months ahead of time. For the system to function, some degree of price stability has to exist. When prices, or in this case, duties are changing rapidly, traders are apt to overcompensate, not knowing whether the worst of the increases are baked in. An increase in duties can force companies to modify supply chains, moving production to different areas in an effort to avoid tariffs. Newer centers of production take time to ramp up and build expertise. When enough of this happens, supplies become constrained, prices rise, and quality suffers. None of these are good outcomes for enterprise or consumers.

As the administration’s trade war intensifies, driven by a president whose instinct is to always double down, we are not complacent about the risks.

A decline in trade levels will impact a wide swath of American industry, which is deeply interwoven into a global network of production. When trade levels fall, we will see this ripple through corporate expectations and outlook, eventually reducing valuations, earnings and prices.

Based on this outlook, we recommend investors maintain caution and adopt defensive positions. Reducing risk assets and holding a portion of portfolios in low risk securities such as short-term government bonds, fixed deposits or cash remains our priority.




Subir Grewal, CFA, CFP                                                                     Louis Berger

2018 Q1 letter: Why the roller-coaster market is back.

2018 Q1 letter: Why the roller-coaster market is back.

As we noted in our 2017 year-end review, we expect 2018 to be a tough year for the domestic stock market. Rising interest rates and valuation concerns are going to be the major story for investors this year. Stock market valuations remain elevated, with the S&P 500 currently priced at 24 times last year’s earnings. This is far higher than the post-war average of 17 times earnings.

The primary justification for high P/E ratios is the extremely low interest rate environment we’ve experienced in this century. For much of the 80s and 90s, interest rates remained above 5% (see chart below). In contrast, since April 2001, US interest rates have kept well below 5%, apart from 13 months spread between 2006-07.

This unusually low interest-rate environment has support stock prices throughout the 21st century. Low interest rates spur higher stock prices for a variety of reasons:

  • Income oriented investors are driven to the stock market since bonds and bank deposits offer very little return.

  • Future corporate earnings are valued more highly since the discount rate is lower.

  • Consumers and companies take advantage of low interest rates to finance projects and purchases cheaply. This spurs sales.

  • Leverage becomes cheap for speculators, amplifying the amount of money invested the market.

When rates begin to rise, all these supportive factors are reversed, acting as a head-wind for stocks. The Fed has signaled that it intends to continue raising interest rates since unemployment is low and the overall health of the economy remains strong. In our view, rate hikes are the crucial factor driving the recent stock market drops, and we believe this volatility will continue.

There’s no denying the market has been more volatile since January. Over the past three years, the S&P 500 has seen 20 days when it was down more than 2%. Seven of those days have occurred in 2018 (and we’re only in early April). As of this writing, the S&P 500 is now 10% below the peak reached on January 26th. Technology stocks, which had seemed relatively immune to the downturn have also begun to sell-off. Over the long-term, we continue to believe technology will become a larger part of consumer’s lives and our economy. However, just as with every industry, business models can change and seemingly unassailable companies can falter. The current, sky-high valuations for many technology companies leave little room for error.

In our view, conditions remain challenging for the stock market, and investors should adopt or maintain defensive positions. This can be accomplished in multiple ways: holding short-term and floating rate bonds, reducing overall allocations to stocks and shifting into more stable stock-market sectors (such as consumer staples).

As we do on a continuing basis, we have been evaluating client allocations and adjusting investments as warranted. Please let us know if you have questions about your portfolio or holdings.

PS. If there is a friend or relative you believe would benefit from a conversation with us, as always, we would appreciate the introduction.




Subir Grewal, CFA, CFP Louis Berger

Income inequality is rising in America, and corporate boards are to blame.

Income inequality is rising in America, and corporate boards are to blame.

That’s what I read into the comprehensive analysis of individual income tax returns by Bakija, Cole and Heim. The Washington Post has coverage of their work. The work is a damning indictment of the manner in which corporate boards have abdicated their responsibility towards shareholders to rein in excess corporate compensation. The compensation process is run entirely by alpha-CEOs and compensation consultants who understand which side their bread is buttered. The board is a rubber stamp.

The paper also throws cold water at the various excuses presented to justify sky-high executive compensation. High-paid sports professionals, doctors or lawyers are not nearly as numerous as high-paid executives.

What should investors make of the big drops in the stock market.

What should investors make of the big drops in the stock market.

Dear Friends,

We rarely deliver a mid-quarter email, but the last two days of large drops in the equities markets and recent conversations with clients have prompted us to provide this update.

On Friday, the Dow Jones Industrial Average dropped 666 points (2.6%), which was followed by a 1,175 point drop (4.6%) today.

The S&P500 (a far broader index of stocks) dropped 60 points (2.1%) on Friday, followed by a 113 point drop (4.1%) today.

Intra-day action was even more extreme, with the market down over 6% mid-day today (almost 1600 points on the Dow).

These drops have brought us 1% below where the market was at the beginning of the year and below where broad markets traded when the tax bill was passed in December.

Though these are large point drops, they are not particularly extreme when seen in percentage terms. 4% one-day drops are relatively frequent, occurring every several years, the last one was in 2011. The Dow has dropped by over 7% on 20 separate occasion, four of those drops occurred in 2008 alone.

In its 95 year history, the S&P 500 (which includes a far larger group of stocks) has dropped by more than 5% on at least 20 separate days. Today’s drop, though severe, did not make it into that list.

Viewed in a broader perspective, these drops are severe, but not extreme.

That said, as we cautioned in our annual outlook, stocks remain at historically high levels with various indicators suggesting headwinds for businesses and stock market investors. Stock market valuations are at cyclical peaks. The US economy has been expanding for 9 years, making this one of the longest booms in history. Job growth has slowed over the past year, signalling some economic cooling, though unemployment remains very low and corporate earnings are strong. Underlying economic conditions are still robust, but elevated valuations remain a concern.

In our view, the recent skittishness in equities markets is driven mostly by interest rates. Interest rates on long dated bonds (10-30Y) have continued to climb. The 10Y treasury yield in particular has risen sharply this year. These long-term rates drive key economic decisions and are one of the indicators we watch closely. The 10Y rate is used to price most mortgages, and many companies use 5-10 year rates to evaluate the costs/benefits of projects and investments. Rising rates increase costs for home-buyers and all long-term investments, reducing activity in these sectors. Rising rates also impact disposable income for investors who carry credit card balances (which are at an all time high), and for investors who trade on margin (margin balances are also at an all time high). Most importantly, rising rates impact corporate earnings. US corporate debt stands at almost $9 Trillion. Not all of it is held by public companies, and  rates on most corporate debt is pre-set for a period of years. Still, every 1% rise in interest rates translates into tens of billions in additional interest expense for corporations, reducing corporate profits.

Though today saw a large drop in longer-term rates as investors rushed to the safety of Treasuries, we believe this is temporary and rates will continue to rise in the near term. The Fed will continue to unwind its bloated balance sheet to the tune of $30 billion a month, providing a source of supply for skittish equities investors retreating to bonds.

Overall, higher interest rates act as a brake on economic activity. It is this anticipation of higher interest rates and an end to the Fed’s unprecedented policy of quantitative easing that is driving the stock market declines.

We reiterate our year-end advice. Investors should adopt a cautious allocation and be aware of the headwinds we face.

Please give us a call at 646-450-9772 if you would like to discuss your specific circumstances.


Subir Grewal, CFA, CFP                   Louis Berger

2018 Economic Themes: Machines, Bitcoins, Space and Technology.

2018 Economic Themes: Machines, Bitcoins, Space and Technology.

Dear Friends,

We trust you’ve had a wonderful holiday season and a good start to the New Year.

As we dig ourselves out from one of the first winter storms and a biting cold front, we have been considering the year ahead and what it may bring for investors. 2017 ended with a remarkable rally in December. This was fueled by the passage of a tax bill that generally favors investors and corporations. Though this tax-bill may have provided some short-term boost to the markets, we believe it’s long term impact will be quite mixed. The bill is estimated to create an unfunded deficit of approximately $1.5 Trillion. This amount of deficit spending would generally give rise to fears of inflation, which seem to have been largely ignored. We are also skeptical about the claim that the bill simplifies the tax code significantly. It is true that a larger proportion of individual filers will now claim the standard deduction, but there are several other complexities introduced by the bill for both individual and business filers which will be argued over by tax accountants for years.

In many other countries, the tax authorities prepare a return/statement at the end of the year for tax-filers which can then be contested/corrected. No such mechanism for low/middle-income Americans is anticipated in this bill. We are also skeptical about claims that the corporate tax cuts embedded in this bill will spur investment or boost anemic wage growth. Corporations are already holding record cash reserves, and wage growth in the US has been slow for decades, largely due to the legislature’s failure to increase the minimum wage. As such, we believe the tax bill will have a limited impact on medium-term prospects. Given our view on the 2018 mid-terms, there is a good chance many provisions will be reversed within a year.

A list of the top 10 economic themes we expect to see this year follows. A graded ranking of our themes from last year is also available.



Subir Grewal, CFA, CFP                   Louis Berger


2018 Economic Themes: Machines, Bitcoins, Space and Technology.


  1. Slow But Steady Rate Rise.  The Fed has signaled no intention to halt its program of bond sales and interest rate hikes. Over $400 billion worth of the Fed’s Treasury bond holdings will come due in 2018. The normalization program announced in 2015 suggests the Fed will not reinvest most of the principal. Many billions in principal repayments on the Fed’s MBS (mortgage-backed securities) holdings will also not be reinvested. In aggregate, we expect the Fed’s normalization actions will withdraw $300-$400 Billion from money supply in 2018. We expect the Fed to maintain the normalization plan and continue tightening rates in 2018 with the Fed Funds rate ending the year in the 2%-2.5% range. Both these actions will place additional pressure on stocks.
  2. Year of the Donkey.  We expect the mid-year election of 2018 to mark a sharp reversal for Republicans, who currently control all three branches of federal government. We expect the Democratic party to win a majority in the House of Representatives and we suspect there is a real possibility (40%) they will take the Senate as well. Such a result would stall or reverse the Trump administration’s legislative agenda. We expect congressional investigations of the administration to intensify as a result.
  3. The Bull Runs Out of Steam.  We expect 2018 to be a difficult year for equities markets given the extremely high levels attained over the past two years. Margin debt is now at all time highs, at 1.6 times the peak reached in 2007. We have been advising caution for the past few years while the market has continued to rise. However, we see no reason to change our short/medium term forecast given stretched valuations and the age of this bull market (now entering its 9th year).
  4. Rise of the Machines.  2017 saw various automation/AI technologies gain a firm foothold among consumers. Siri, Alexa, Google Home and several voice activated car-technologies have become second nature to millions of people. We believe this trend will continue in 2018 and we will see the initial emergence of voice-activated AI/automation being married with robots/machinery. This has already begun in cars, but we expect intelligent home devices to begin controlling autonomous vacuum cleaners, window washing drones and other small devices. As we did in 2017, we expect AI/Automation stocks to outperform consumer discretionary stocks.
  5. International Beats Domestic.  We expect international stocks, especially European markets, to outperform the US in 2018. Emerging market fundamentals remain broadly positive, and we expect these markets to perform reasonably well while we are expecting a negative year in the US.
  6. Bitcoin Bust.  2017 saw immense interest in crypto-currencies, particularly Bitcoin. Prices were driven up by sky-high demand and fixed supply (the total amount of Bitcoins in circulation increases only by a very small percentage each year). The sharp rise was partially fueled by speculation around new ETFs that seek to track Bitcoin prices and open up the market to more traditional investors. We believe some of the technologies embedded in Bitcoin, especially the peer-to-peer transactions and public ledger/blockchain, are innovative and do have a future. That said, Bitcoin prices themselves are in a speculative bubble which we expect will reset in 2018.
  7. Renewables Redux.  2017 saw renewable energy YieldCos outperform conventional fossil-fuel based electric utilities. We expect this trend to continue through 2018 as YieldCos will benefit from robust demand for renewably sourced electricity (by both the public and private sectors), increased efficiency from solar and wind power, newer fleets that require less maintenance and a smaller scale that allow them to operate more nimbly compared to their conventional peers.
  8. Organics Go Mainstream.  Organic food products are the fastest growing segment of the US food industry. Sales have increased by high single digits in recent years while the overall food market has remained stagnant. Though some of the major food behemoths have launched their own organic food lines or acquired smaller start-ups, they continue to play catch-up in this arena. We think organic food stocks will outperform conventional food stocks this year.
  9. New Dawn of Space Race.  2018 will see a number of commercial space ventures mark milestones, including manned-flight into low-earth orbit and potentially a lunar orbital space tourism mission. As commercial space missions become routine and the prospect of mining asteroids and the moon becomes a reality, we expect a secular rethinking of the prospects for natural resource mining enterprises that are earth-bound. The trend itself will take a couple of decades to reach fruition, but we expect earth-side mining for certain materials to decline over time in favor of extraction in space. We realize this sounds far-fetched, but technological changes over 20 year cycles can be immense (for example, compare internet ubiquity with where we were in 1997). The technology to permit the creation of largely automated mines on the moon or an asteroid are largely available today.
  10. Net Neutrality Fallout.  Though the revision of net neutrality rules was overshadowed by the tax bill negotiations, it was a landmark change. We expect to see tangible impact to the way consumers experience the internet as a result of the FCC’s contentious decision to remove net neutrality.  This reversal tilts the playing field towards telecommunications companies and away from content providers. We expect telecommunications firms will seek to exploit the ability to meter bandwidth and extract rents from content providers. ISPs will start to create fast lanes and we may see some of the large content firms seek to create their own networks. Telecommunications firms have risen in the past month as a result of this ruling, but we believe the medium and longer term prognosis is less rosy, with the prospect of new entrants and even more consumer dissatisfaction.
Review of 2017 Themes: The Doldrums

Review of 2017 Themes: The Doldrums

2017 was an uneven year for our market predictions. We were right on five calls, half right on one call and wrong on four calls. Continued bullishness and investor support for the Trump administration (despite abysmal poll numbers) torpedoed three of our calls.

  1. ? Fed stays the course: We expect the Federal Reserve will continue to raise rates as stated. We expect the Fed-Funds rate to rise above 1.5% over the course of 2017. The Fed started 2017 with a target interest rate of 0.50%-0.75% and finished the year with a target rate of 1.25%-1.50%. While the Fed raised rates, they met but did not exceed 1.50%, so we’re giving ourselves half a point on this one.
  2. × Equities Caution: We continue to advocate for a cautious allocation to stocks and expect to see negative returns for US equities this year. We were dead wrong on this call as US equities continued their bull market run through year eight.
  3. ? Artificial Intelligence: We expect performance for companies providing intelligence features in devices to outpace the consumer durables index over the next three years, we will evaluate ourselves annually on this call. Artificial Intelligence-related companies had a very strong 2017 as the Global Robotics and Artificial Intelligence Index was up 57.62%. Comparatively, the S&P 600 Consumer Discretionary Index was up 17.13%.
  4. ? Continental shifts: Over the next several years, we expect Indian markets to outperform those in China and the developed world. We were right on year one of this call. The S&P BMI India Index was up 29.56% in 2017. This compares to 26.67% return for the S&P Greater China Index and 21.83% return for the S&P 500 Index.
  5. × European upheavals: We believe European stocks to be more attractively priced than US equities…we expect European stocks to outperform US equities. While European stocks performed in-line with our expectations — S&P 350 Europe Index was up 10.75% on the year — the unexpectedly strong performance of US stocks (21.83% return for the S&P 500 Index) easily outperformed this total.
  6. × Dollar strength continues: We expect the dollar to remain strong against major currencies worldwide. Despite rising interest rates, the USD weakened against a basket of international currencies in 2017.
  7. ? Drones are going to be delivering much more than bombs: We expect companies building these technologies to outperform the freight and shipping transportation companies. While we view this as a long term trend, 2017 saw drone-related companies outperform. The Solactive Robotics and Drones Index was up 38.7% while the S&P 500 Transportation Index was up 23.52%.
  8. ? Renewable Utilities: Though the incoming administration is not supportive of renewables, we think renewable utility companies or YieldCos will outperform conventional, fossil-fuel based utility stocks. YieldCos saw a strong rebound in 2017 and handily outperformed traditional utilities. The Global YieldCo Index saw returns of 22.87% while the S&P 1500 Utilities Index returned 12.16%.
  9. ? Retail Real-Estate: We expect real estate companies that own large portfolios of malls and brick and mortar stores to underperform other real estate investments. This prediction came to fruition as brick and mortar stores, and particularly malls, continued to see a decline in foot traffic and a loss of market share to online shopping in 2017. The FTSE NAREIT Regional Malls Index was -2.68% and the FTSE NAREIT Shopping Centers Index was -11.37%. Meanwhile, the FTSE NAREIT Composite was up 9.29%.
  10. × Optimism about Trump presidency short-lived: We expect any investor-optimism surrounding the Trump presidency to evaporate rather quickly in 2017 as markets find he is unable to follow through on his lofty campaign promises. As we expected, President Trump has been unable to follow through on his campaign promises, and his approval ratings are among the lowest ever recorded for a first year presidency. However, a strong economy, robust corporate profits and the prospect of a tax cut allowed investors to shrug off his policy failures, chaotic management style and a criminal investigation to send equity markets to all-time highs.
Powering down the Fed’s bond buying engine.

Powering down the Fed’s bond buying engine.

We trust you’ve had a restful and enjoyable summer.

This was a difficult hurricane season for many of our fellow Americans, especially those in Puerto Rico and across the South. A number of category 4 and 5 hurricanes made landfall in the US, causing enormous damage in Puerto Rico, Houston, Florida and the Virgin Islands. Several Caribbean islands have suffered almost complete devastation. Aside from the enormous human toll exacted by the loss of lives and homes, the hurricanes have also impacted US industry. Several sectors were impacted, including tourism, oil and pharmaceuticals (Puerto Rico is home to several pharmaceutical plants). Many hourly workers missed work for days or weeks, affecting their earnings. The impact is visible in the September jobs report, which shows a loss of 33,000 jobs.

This loss breaks a consecutive streak of 83 months of employment gains, stretching back to 2010. Markets largely shrugged off the terrible jobs report due to these effects, which are believed to be temporary. We expect October’s report will be skewed in the other direction as many workers head back to work.

Taking a longer term view, it seems clear that man-made climate change leads to warmer ocean and air temperatures. These conditions produce larger, more destructive storms which arrive with greater regularity. In the West, we have seen a series of destructive forest fires this year. Climate change has also expanded the range of invasive insect species which have killed off large stands of trees in our forests. Under hot, drought conditions brought on by global warming, these dead trees become kindling for forest fires. Our changing climate will pose major issues for insurers/re-insurers and local governments, particularly in flood and drought-prone areas. Communities will have to review zoning regulations in the face of these fires and storms. The cost of adaptation and recovery will be high, and doubtless some communities will be unable to recover fully.

The Fed has signaled it will treat the September jobs report as an outlier and stick with its plan to normalize monetary policy. This is almost certain to include one more interest rate hike before year end, likely in December. The Fed has also indicated it will proceed with its plan to reduce its 4.5 Trillion dollar holdings in bonds. These were purchased between 2008 and 2014 as part of the “quantitative easing” program, in an effort to stabilize financial markets. Based on its published plans, we expect the balance sheet to shrink by 250 Billion in 2018 and up to 400 Billion in 2019 and subsequent years, depending on economic conditions. These are substantial numbers, and we expect them to maintain steady upward pressure on interest rates across the maturity curve. We expect Janet Yellen will be replaced as Fed Chair when her term ends at the end of Jan 2018. This raises critical questions about the Trump administration’s ability to nominate and confirm a candidate who is credible and seen as independent of political pressure.

Stock markets continued their upwards drift, hitting new highs this quarter. These moves were supported by steady economic numbers, including GDP and employment. Corporate earnings have also remained steady, though insurance sector earnings are expected to be down significantly in the third quarter. Gains have been led by the technology and financial services sectors, which have grown to become the largest components in the S&P500. Both sectors are cyclical, and in our view a long expansion and the increasing ubiquity of technology has driven some of these stocks to unsustainable levels.

The market seems to have largely ignored Washington, tuning out several dramatic weeks in Congress as major legislation to transform health-care, infrastructure and deregulation have stalled or collapsed. A Republican effort to pass a tax reform bill is still underway, but it looks increasingly unlikely that this effort will pass either. The tax reform package proposed has not been scored by the CBO, but most analysis indicates it will add to the deficit. The proposal includes several modifications to deductions and tax brackets. Overall, its impact would be to reduce the tax burden on the very wealthiest of Americans, and shift some of those charges on the poorest and on Americans earning less than 400k a year. The scale of the proposal, the major uncertainties involved, and the haphazard manner in which it was developed lower the chances of passage. We do not believe the tax reform proposal will be enacted in its current form. At best, we believe the administration may be able to pass a severely watered-down bill.

Looking ahead to the end of the year, we expect equities markets to largely ignore Washington DC, unless the administration managers to pass significant legislation. The prospect of interest rate hikes and the Fed’s plans to shrink its balance sheet are likely to exert downward pressure on stocks. We continue to maintain our defensive positioning, with lower than average allocations to higher-risk assets like stocks and long-term or high-yield bonds.




Subir Grewal, CFA, CFP                           Louis Berger

2017 Q2 letter: A threat to human civilization

2017 Q2 letter: A threat to human civilization

Dear Friends,

The 2nd quarter saw the Fed continue its strategy of withdrawing stimulus from the US economy. Since December 2016, the Fed has raised rates three times, bringing the target rate up to 1.25%. Their most recent statements suggest the target rate will continue to rise if unemployment and inflation stay relatively stable. There have been several statements this month from Fed governors indicating the central bank plans to begin selling or rolling off the 3.6 Trillion dollars in bonds it has acquired since the financial crisis of 2008/2009. The Fed’s decision to increase its bond holdings by 400% during the financial crisis was an unprecedented action, and the reduction to more normal levels has been expected for some time.

The net effect of these moves for investors will be a rise in interest rates, a reduction in liquidity, and a less attractive environment for risky assets. Bond investors should see rates continue to rise towards more normal levels, a relief since bond yields have been historically low for the past several years. The sale of the Fed’s bond portfolio will also reduce the amount of money in circulation (the money supply) as private investors purchase the assets the Fed sells. This is expected to put further pressure on stock prices and riskier assets as funds are directed into these purchases.

Over the past few days, we have also seen the risk of political instability in the US rise to remarkable levels. It seems increasingly likely that the various investigations underway may lead to very senior members of the Trump administration and campaign facing a variety of charges.

From a valuation perspective, stock prices continue to look overvalued. Remarkably, the top five components of the S&P 500 (Apple, Alphabet/Google, Microsoft, Facebook and Amazon) are all technology companies. What’s even more surprising is that with the exception of Apple, they are all trading at prices over 30 times earnings. Much of that gain has been recent, four of the  five have seen gains of over 20% in the past six months (the exception is Microsoft). Taken together, these five companies represent almost 12.5% of the index.

Overall market valuations are extraordinarily high, with the current P/E ratio for the S&P500 over 25. A longer term measure, which looks back at ten years of earnings (Cyclically Adusted or Shiller P/E) is illustrated in the chart below, alongside interest rates. Cyclically Adjusted P/E is at levels that have only been exceeded twice; before the tech-wreck of 2000 and Black Tuesday in 1929. This is partly because interest rates remain at historic lows. As discussed above, that is changing.

As a result of these factors, we continue to maintain a defensive posture and recommend clients an underweight allocation to high-risk assets.

Data source: Robert Shiller – Yale University

We would like to use the rest of our quarterly letter to discuss a longer-term risk, one that impacts not just the markets, but all of human civilization.

For several decades now, scientists focused on studying global warming and climate change have shared their increasingly dire findings about the impact of human activity on the Earth’s biosphere. It is now abundantly clear to all, except the intentionally obtuse and dishonest among us, that human activity has impacted the Earth’s climate in a significant way. Our species’ use of fossil fuels has released an extraordinary amount of greenhouse gases into the atmosphere, raising the average temperature across the world by 0.2° Celsius (0.36° Fahrenheit) each decade.

Economists have long understood that markets can mis-price public goods or services that have concentrated benefits for a few while costs are diluted among many. Within the economic literature, this is called the “tragedy of the commons”. The classic example is shepherds grazing their flocks in a meadow that is commonly owned. In standard political and economic theory, the government is meant to intervene to enforce a solution that furthers the general good and recognizes and allocates the true costs of such activity.

At this point, we should admit that US political institutions have failed to deliver on addressing climate change. The vast majority (85%) of greenhouse gases released into the atmosphere have been generated since World War II. Over that period, the United States has been, by far, the largest greenhouse gas emitter. So, much of the responsibility for climate change lies with us. Yet, we have been for decades, and still remain, the chief impediment to decisive action on climate change. The Trump administration has made a very bad situation even more dire by announcing a withdrawal from the Paris agreement.

Nature, of course, couldn’t be less concerned about human politics. The content of greenhouse gases like carbon dioxide and methane has continued to rise, driving surface temperatures higher. This has manifested itself in a variety of ways. Glaciers have retreated across the world. The five hottest years in recorded history occurred within this decade, and 2016 set a new record. Coral reefs across the world are bleaching as water temperatures rise, stressing the marine eco-system. Hotter summers are impacting humans as well, with extreme temperatures rising causing heat-strokes, dehydration and deaths.

Most climate change models have assumed a 0.2°C increase per year in surface temperatures will leave the Earth’s with an average temperature 2°C (3.6°F) higher by 2100. Those assumptions now look woefully inadequate. Since we have not measurably reduced our greenhouse gas emissions, and the Paris agreements seem to have collapsed, 2°C degrees is an underestimate and the case for a 3-4°C rise becomes stronger.

As climate change and research into it has advanced, the risks of a runaway feedback loop have become clearer as well. Permanently frozen ground in the arctic regions of Asia and North America traps a large amount of methane. As the ground gets warmer, this methane leaches into the atmosphere. As temperatures rise and water becomes scarce, plant life across the world will be stressed. The risk and incidence of forest fires increases, and the loss of trees leaves more CO2 in the atmosphere. If rising temperatures, fire and drought impact major CO2 sinks like the Amazon forest, temperatures will rise even faster.

There is a reasonable likelihood that temperatures will have risen by 4-6°C (7-10°F) by 2100. 90°F days will be 100°F days. 100°F days will be 110°F days. Phoenix saw temperatures rise above 118°F last month, grounding flights. What happens when temperatures approach 128°F? If such an extreme rise in temperatures were to occur, the world is looking at a series of major catastrophies that could largely destroy human civilization.

Drought and heat would cause widespread human suffering and deaths. Food stocks would be harder to grow with much of the world’s breadbasket regions in China, India, Central Asia and North America undergoing desertification. Much of the southwestern United States could become an uninhabitable desert. Tens of millions of people would need to be resettled. This pattern would be replicated across the world. A NASA study indicates the Middle East is suffering through a 20 year drought that is more severe than any in the past 900 years. There are indications that crop failure and rising food prices have contributed to societal upheaval in the region. The Mediterranean as a whole is susceptible to drought and desertification.

The impact on agriculture worldwide would be many times more severe than seen during the dust-bowl. Marine life and fisheries would be devastated as ocean temperatures rise. And yes, sea-levels could rise 10 feet or more, making most coastal cities uninhabitable without civil works on a scale we have never seen before. Much of New York, London, Mumbai, Shanghai, Sydney, Rio De Janeiro, Singapore, Dubai, Miami, almost all of Bangladesh, and many island nations, would be lost.

It is virtually certain that such extreme conditions will lead to widespread forced migrations and fuel conflict between nations and individuals. This is one of the reasons the US Department of Defense treats climate change as the largest strategic threat to the country. Governments and political structures will undergo immense stress and opportunistic charlatans could come to power across the world.

All of this would significantly impact incomes, growth rates, earnings and most importantly health and well-being. We do not intentionally seek to be alarmist. However, the data and projections we have seen demand urgent responses and are alarming. There is a grave likelihood that we leave our children with a world in crisis. Without urgent, concerted action, large portions of our planet will become inhospitable to human inhabitation within our children’s lifetime.

Clearly, these events will impact investors and markets in profound ways. As we engage in long-term, inter-generational planning for clients, we want our clients to know that we take these risks very seriously and will continue to keep these considerations in mind.







Subir Grewal, CFA, CFP                                                                                              Louis Berger

2017 Q1 letter: Renewable energy in the Trump era

2017 Q1 letter: Renewable energy in the Trump era

Dear Friends,

The first quarter of 2017 was full of eventful news for markets. We saw a Fed rate hike, record low unemployment rates, all time highs for US equity markets and a new administration sworn in, with Republicans now in full control of Congress. In our view, this likely marks an inflection point for the current business cycle and market levels.

Since the election, we have received several queries from our socially responsible investors about the fate of environmental and climate change regulation under the Trump administration. We understand and share many of their concerns. We hasten to add, however, that infrastructure spending and projects are usually undertaken with long time frames in mind. Enterprises making decisions about what kind of power plants to build will consider the costs over a long term. They are well aware that the current administration and its policies are not set in stone.

We do not expect a raft of coal plants to be built over the next four years — in fact, 2017 has seen an acceleration of the closure of several legacy coal plants. Large plants typically take 3-5 years to build and operators have to factor in the possibility that they will face a changed regulatory environment just as the plants come online. Natural gas prices are likely to play a much larger role in determining what resource mix generates our electricity. The cost of utility scale renewable solar power continues to fall, and though it is not yet competitive with cheap gas, it is not far off either. The IEA estimated the average capital costs of photovoltaic solar plants under construction to be 35-45% higher than natural gas plants per unit of energy produced. An array of tax credits make solar competitive with gas. though the precise economics are driven by regional factors and weather. Wind and hydroelectric power are already competitive with natural gas.

At the risk of appearing sanguine, we think that technological advances, consumer preferences, and the economics of scale have brought us to the point where renewable energy will be competitive with conventional electricity generation going forward. Installed renewable capacity will continue to increase, with or without incentives. If fuel costs move higher, renewables will be become very attractive.

In our view, purchasing certain sectors based on the administration’s stated policy preferences is unlikely to lead to consistent gains. Our reasoning is based on the Trump administration’s penchant for changing direction at the drop of a hat, and secondly on the opposition to various aspects of their policy agenda from either side of the aisle in Congress. In the medium and long-term, valuations and the business cycle will determine investor success. Neither looks particularly fortuitous at the moment for risk assets (equities, or long-term/lower-quality bonds). We continue to recommend a defensive shift for clients based on these factors.


Subir Grewal, CFA, CFP Louis Berger