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.

posted in: Bonds, Economics, Quarterly Letters, Stocks | 0

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.

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.

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.

posted in: Bonds, Markets, Stocks | 0

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