Spare Us the GDP Agony – Brian Wesbury, First Trust

Real GDP grew at a 2.6% annual rate in the fourth quarter, and while some analysts are overly occupied with this “slowdown” from the second and third quarter, we think time will prove it statistical noise.  Even at 2.6%, the pace is a step up from the Plow Horse 2.2% annual rate from mid-2009 (when the recovery started) through early 2017.

Fourth quarter real GDP growth happened in spite of a huge decline in retail sales for December (itself suspicious and likely to be revised higher, as job growth and retailer reports painted a different picture).  Moreover, business investment grew at a 6.2% rate in Q4 and was up 7.2% in 2018, the fastest calendar growth for any year since 2011.

In 2018 as a whole, real GDP grew at the fastest pace for any calendar year since 2005.  And what’s even more impressive is that year-over-year real GDP growth has accelerated in every quarter since the beginning of 2017.  The first quarter of 2017 was up just 1.9% from a year earlier while subsequent quarters showed four-quarter growth of 2.1%, 2.3%, 2.5%, 2.6%, 2.9%, 3.0% and now 3.1%. We expect Q1-2019 GDP to slow like many other Q1s in recent years, meaning this impressive streak may come to an end.  But this too is just statistical noise, and the YOY trend should remain around 3%+ over coming quarters.

“Potential growth,” a measure of how fast the economy can grow when the unemployment rate is stable, has also improved. It’s calculated using “Okun’s Law,” which says that for every 1% per year the economy grows faster than its potential rate, the jobless rate will drop by 0.5 points.

Working backward from the unemployment declines of recent years shows that potential GDP growth has picked up.  From mid-2010 thru mid-2017, potential real GDP grew at just a 0.6% annual rate.  But in 2018, with real GDP growth of 3.1% while the jobless rate dropped only 0.3 points, potential growth was 2.5%.

The worst part of the GDP story is the political gamesmanship of those who say real GDP only grew 2.9% in 2018.  These data distorters are not looking at the size of the economy in the fourth quarter of 2018 compared to the fourth quarter of 2017; instead, they are comparing production through all of 2018 to production in all of 2017.

Here’s why their method is misleading.  Let’s say that in the first quarter of Year 1 a company earns $100 per share then earnings slip to $99 in Q2, $98 in Q3 and $97 in Q4.  Then, in Year 2, earnings start at $97 per share in Q1, go to $98 in Q2, $99 in Q3 and finally back to $100 in Q4.  Overall, for two years earnings per share were flat.  But that’s because earnings growth was bad in Year 1 and good in Year 2.  But the misleading method used by those saying the economy only grew 2.9% in 2018 would compare total earnings in Year 2 ($394) to total earnings in Year 1 ($394) and say the company had zero growth in Year 2!  But that’s nonsense.  What matters in measuring Year 2 is how much earnings grew during the year, and in our example, that was 3.1% in Year 2.

More commentary from Brian Wesbury can be found on his blog.

Inspiring Podcast by Great Investing Minds

Check out this podcast by one of our top investment providers, ARK Investment Management.  In Episode 9 of FYI (For Your Innovation) you are going to hear from three people.  The conversation is led by moderator James Wang (ARK Analyst) as he facilitates a conversation between Catherine Wood (ARK CEO/CIO) and Dr. Art Laffer (Laffer Curve Economist).  During the 33-minute talk they cover innovation cycles, tax policy, global trade, genetics and cancer.  A truly inspiring, power packed podcast, on investing in disruptive innovation.

The Big Four Indicators (12/7/18)

The Dshort website (part of Advisor Perspectives) hosts an incredible about of economic and market data.  Periodically I feature some of their work, specifically The Big Four Indicators update.  Taken together, these four indicators covering income, employment, retail sales and industrial production are thought to be an excellent monitor of the overall health and direction of the U.S. economy.

Advisor Perspectives, Jill Mislinski, December 7, 2018

The recovery from the Great Recession has been slow but positive.  The most encouraging development recently has been the strength coming from industrial production (purple line).

Sellers Push Markets Lower; Most Stock Breakouts Hold

After a swift and intense decline in October, U.S. stocks are trying to rally but face renewed selling pressure in November.

One of the current challenges is the performance of international stocks.  The economic recovery and central bank policies of Europe, Japan and China continue to lag results in the U.S.  This divergence has created a significant valuation gap and instead of international stocks catching-up to the U.S., investors may be looking to revalue U.S. stocks lower.

Here is a look at the Price to Earning (P/E) and Price to Book (P/B) ratios of international (EFA) and emerging market (EEM) stocks compared to the S&P 500 (IVV).

IVV  P/E 23.29, P/B 3.33  (U.S. Stocks)

EFA  P/E 13.87, P/B 1.59  (Developed Country Stocks)

EEM  P/E 11.94, P/B 1.52  (Emerging Market Stocks)

State Street, BlackRock, Dightman Capital as of 11/12/18

As the data above shows, U.S. stocks are trading at a premium to the rest of the world.  The P/E ratios above are calculated using 12-month trailing earnings.  If 12-month forward earnings estimates were used the P/E ratio for US stocks would be significantly lower.  Strong earnings growth projection for U.S. stocks explains why there is such a large difference between trialing and forward P/E calculations.

The risk to U.S. markets is a reduction in the P/E and P/B ratios through lower stock prices despite a healthy U.S. economy and corporate earnings environment.  Stocks could trade down another 10-20% from current levels to narrow the gap but U.S. stocks should be able to maintain their independent valuation despite lower growth and valuations in other parts of the world.  This would be based on continued sales and earnings growth.  High growth environments are often reward with premium valuations.  In terms of opportunities in international stocks, eventually they may represent an attractive investment opportunity but as a group they appears to have more economic work to complete before they can stage a strong recovery.

Interestingly, leading growth stocks have held-up pretty well during the selling this past week with the number of stocks reaching new highs for the NASDAQ well above lows back in October.

It will be important for the New Highs-New Lows index to move back into positive territory.  The performance of leading stocks is an important sign of when to potentially take defensive action.  If high-growth stocks are holding up in a market correction, the likelihood of a bear market is lower.

End of This Cycle

Some commentators are suggesting we are at the end of this cycle.  However, they may be failing to recognize that in this cycle we spent the first 8 years in repair mode and only recently began a phase of strong economic growth.

Weak Credit Markets

Another clue to the health of the overall environment can be found in credit markets.  Some commentators have suggested the flat yield curve is a sure sign of a pending recession.  What they may fail to realize is this is a common occurrence for years leading up to a recession as short-term rates move higher while long-term rates remain somewhat anchored due to a deflationary trend cause by globalization.  We are only one-year into a rate rising process and remain at very low rates.  Some rate sensitivity has been reported which may help The Fed pause at some point in 2019.

High-yield bonds are holding up well which is something we would not expect if we were moving towards a change in the market cycle.

Mid-Term Results

The stock market had a strong day on November 7th and some observers believe there is a reasonable chance of an infrastructure bill passing which should be well received by the market.

Trade Negotiations

In terms of the international trade, progress has been accomplished.  However, China and the U.S. have very different approaches, definitions and attitudes on the subject which could mute economic growth next year if an agreement is not reached.

There are always risks and “what if” considerations when monitoring market cycles.  On balance I believe we are still in an expansionary phase economically which could last longer than many people anticipate.  There are risks and conditions could change quickly but in total I believe the current selling is corrective in nature, and even if we see additional declines, I believe stocks will resume the current uptrend.

Brutal Correction

Back on October 15th in market commentary I wrote, “A scenario is developing which could push stocks further into the red in the coming days and weeks…”

On October 20th I wrote, “I do not expect the current situation to resolve itself quickly.”

To be fair, the stock market could have moved higher from each of those dates, but it hasn’t, the selloff has intensified.  There is one primary reason I felt it could get worse before it gets better.  This is a mature market.  I don’t believe the I bull market is over.  I do believe, for it to continue advancing, values need to be reset and that is what is happening.

Those investors with more than a few years of investment experience know that periodically we enter into corrections and occasionally bear markets.  The difference between a correction and a bear market has to do with the degree of the decline.  Bear market also usually last much longer.

The primary culprit of the current sell-off is interest rate related.  The good news is that a statement by the Fed that they are going to review future rate hikes and reconsider their plans could stabilized the market.  This is likely to happen if the situation deteriorates any further.  A credit/consumption-based economy is very sensitive to interest rates.  Like a ballast, interest rates have the potential to tip the stock market if they rise to far too fast.  Several real estate reports have recently indicated a slow-down in activity being attributed to higher interest rates.

Corrections are a necessary part of investing.  They allow the market to reassess value.  Higher interest rates require future cash flows for stocks to be discounted at a higher rate causing them to be worth less. Once the market has revalued stock prices based on higher interest rates the bull market underway should continue.  A pause in rate hikes could make this process smoother.

It is possible we could see the situation deteriorate further.  If it does investors are best served to hold tight.  Often the market overreacts in this type of situation but eventually sprints higher.  You don’t want to be out of the market when that happens.

Of course, investments in money markets, bonds and gold can provide some refuge during difficult stock market conditions.

Triggered Alerts – 10.23.18

Marketsmith, Dightman Capital

Immediately at the open this morning I had two alerts trigger.  One alert was for stock based investment that was under selling pressure.  The volume of shares traded immediately at the open was much larger than normal.  Overall, the price was down around 2%; firmly below the 200dma (black line).  As I suggested in recent commentary related to the current selloff, the additional selling I thought had a good chance of materializing has arrived.

Marketsmith, Dightman Capital

The other alert I received this morning was related to gold.  The ETF GLD gapped up at the open and looks poised to continue climbing.  This is the type of action you look for from gold in a portfolio.  According to ETFReplay.com, the ETF GLD has a correlation to the S&P 500 ETF SPY of +0.08, which is only slightly positive.  Correlations have a tendency to change and right now gold appears to be delivering a negative correlation, which is what you what to see during a stock market selloff.

Evaluating Current Market Support and Breakout Levels

Stock market trading settled down this past week providing an opportunity to evaluate trading levels and set technical alerts for support and breakout points.

Below is a snapshot of a equity investment I follow closely.

As you can see in the chart, it has been seven days since the investment closed below the 200 day moving average (Black Line Below Price Bars).  During the last 5 trading days support has been held at this line.  Notice the investment has closed just above this support the last two days and at the bottom of the range of the trading range (Small Horizontal Line Across The Longer Vertical Blue & Red Lines Represents The Closing Price).  Volume has been heavy (red and blue vertical bars in the section below the price) which suggest sellers were met with an equal level of buying at these prices.

Marketsmith, Dightman Capital

The first support level for this investment is currently near the 200dma (day moving average).  There is also support at the bottom the price range where this investment traded below the 200dma.  It is too early to tell if we will revisit those levels again but so far buyers have been willing to come in and support a price above the 200 day line.  Continued support at the current price level would suggest the worst of the selling is behind us.

Trading this last week has also provided a potential break-out price level.  If the price of this investment moves above the trading level from 3 days ago, that would indicate buyers have regains some control which may indicate the worst selling from this correction is behind us, increasing the likelihood we rally into year end.

I do not expect the current situation to resolve itself quickly.  I believe investors are reluctant to come into this market because so many commentators are suggesting this is the beginning of the end of this bull market.  It believe they are wrong and those investors that take an overly defensive position into 2019 may be leaving money on the table.

We have two big dynamics at play that are supporting this market.  A strong U.S. economy, which we have not had since the Great Recession of 2008, and a technology renaissance touching a wide variety of industries.

2018 Investment Strategy Review

Stock and bond market performance has been more volatile in 2018.  After an amazing run in 2017 stocks have become more sensitive to interest rate hikes and potential disruptions in global trade because of ongoing trade negotiations by the Trump administration.

Bonds too have seen an increase in volatility as the Federal Reserve increases the Fed Funds rate and sell bonds from their balance sheet.

The start of the year was extremely volatile for both asset classes but over the last month U.S. stocks and bonds have settled down.  Other asset classes are still struggling.  Emerging market bonds are down over 4% and emerging market stocks have declined nearly 10% according to statistics from ETFReplay.com.

Over the years I have tracked the performance of 4 classical investment strategies from pillars in the industry. Here is a quick look at how they are doing so far in 2018.

Note:  This data is historical and does not reflect actual account performance.  Please see the performance disclosure below for additional detail.  The benchmark for each strategy is the iShares Moderate Growth ETF (AOM).  It is important to remember the CAGR (Compound Annual Growth Rate) for all these strategies are only  using approximately 6 months of data.  Year-To-Date (YTD) performance and volatility is provide below each summary.

We start with our baseline “Classic” Strategy Year-To-Date (YTD) performance.  This strategy is considered a blue-chip approach to investing by several well respected investors.  This mix of investments represents 60% U.S. stocks and 40% U.S. Bonds.

YTD:  Classic Return:  2.8% vs. AOM Return 0.0%     Volatility:  9.7% vs. AOM Volatility 6.0%

Next, we will look at the YTD performance 3-asset class strategy we call the “Cycle” strategy.  This strategy holds 5 investments from 3 asset classes.  It is the lowest volatility strategy I manage.  The benchmark for this portfolio is the iShares Moderate Growth ETF, AOM.

YTD:  Cycle Return:  0.6% vs. AOM Return 0.0%    Volatility:  5.5% vs. AOM Volatility 6.0%

Adding more asset class, next we feature a “risk parity” strategy YTD performance.  In this approach 7 asset classes are weighted based on their volatility (or risk) with lower volatility investments receiving a higher weight.  The benchmark for this portfolio is the iShares Moderate Growth ETF, AOM.

YTD:  Risk-Parity Return:  -1.7% vs. AOM Return 0.0%    Volatility:  4.1% vs. AOM Volatility 6.0%

Finally, the most diversified of the bunch, the 10-asset strategy YTD performance.  This approach invests equally in 10 asset classes.  The benchmark for this portfolio is the iShares Moderate Growth ETF, AOM.

YTD:  Ten Asset Return:  -0.4% vs. AOM Return 0.0%    Volatility:  5.8% vs. AOM Volatility 6.0%

It is clear 2018 has not favored highly diversified strategies.  Those strategies that focus on U.S. stocks have performed better.

For a real shocker, here is how 10 select industry groups I incorporate into my strategies have performed YTD.  This is an all stock selection, so the benchmark has been changed to the S&P 500 (SPY).

YTD:  Industry Group Stocks Return:  16.3% vs. SPY Return 5.6%    Volatility*:  19.5% vs. SPY Volatility 16.1%

*Note the significant increase in volatility associated with the portfolio of Industry Groups.  That is the trade-off for exposure to high-growth areas of the economy.

We don’t know what the future holds but as we embark on a new generation of product and service innovation, along with stronger economic performance in the U.S., I have been guiding clients to overweight U.S. stocks and incorporate industry groups from areas of the economy expected to grow faster than the general economy.  It has been working well and has the potential to add value for years to come.  In addition, I can include industry group exposure to any of the strategies above where risk-management characteristics should generally reduce volatility.

All the statistics provided by ETFReplay.com.

Past performance does not guarantee future results.  Investments and the income derived from them fluctuate both up and down.  Investments at Dightman Capital are subject to risks including loss of principal.  No specific investment recommendations have been made to any person or entity in this written material.  This presentation is for informational purposes only and is neither an offer to sell or buy any securities.  Benchmarks or other measures of relative market performance over a specified time period are provided for informational purposes only.  Dightman Capital does not manage any strategy toward a specific benchmark index.   A variety of sources we consider reliable have provided information for this presentation, but we do not represent that the information is accurate or complete.  Dightman Capital Group does not provide tax advice to its clients.  Conduct your own research or engage an investment professional before making any investment decision.  Investors are encouraged to discuss any potential investment with their tax advisors.  The material provided herein is for informational purposes only.  Data Sources:  IDC, Dightman Capital.

Uncorrelated Assets Still Terrific

One of the strategies I developed for my investment management services is closely related to what has been called the “All Season” or “Permanent” portfolio.  The idea behind this type of investment approach is to deliver a low volatility, reasonable rate of return that can weather any type of market environment: bear market, inflationary, stagflation, etc.  This investment approach has been featured by many different successful investors including Ray Dalio, Cliff Asness, & Harry Browne.  I studied their work and developed my own version.

What make the approach work is using high volatility but low correlated investments.  Take gold for example.  It’s long-term rate of return is mediocre, especially given its high volatility.  What can make gold glimmer, however, is its historically uncorrelated nature.

I recently heard a popular investment newsletter podcast suggest this approach has not worked since 2009.  The shows presenters claimed that correlations have risen, and the strategy has not been performing as expected.  I was surprised by the claim because it has been performing exactly as expected, both as a stand-alone strategy and also as a multi-model approach.

Just to be sure, however, I tested correlations from pre-2009 through 2018 and found very little evidence correlations have risen.  I am not sure if they were mis-informed or just trying to sell more newsletter but I though it was a disservice to highlight “All Season” and “Permanent” portfolio creators and then suggest the approaches don’t work anymore.  So let me be clear, my version of the “All-Season” and “Permanent” portfolio continues to deliver low correlations between asset classes.

Here is a look at the matrix I created comparing correlation of the four asset classes in my approach.

ETFReplay, Dightman Capital, July 6th, 2018

My strategy has not experienced a high degree of correlation and the numbers above suggest the environment has not been one of high correlation.

It is important to understand correlations change.  In my test I looked at 60-day correlations, that is, the price movements between the two assets over rolling 60-day periods going back about 12 years.  As you can see from the examples below, correlations change a lot during short periods, which is a good reminder why a long-term investment perspective is needed.  Perhaps the newsletter writer in the podcast happen to peak at the numbers during a period where correlations moved higher.  As graphics below illustrate, correlations between gold and stocks , for example, do bounce around.

 

 

 

 

 

 

 

 

 

 

If we extend the rolling period to 120-day, we see correlations smoothed considerably.

 

 

 

 

 

 

 

 

 

 

I refer to my strategy as the Cycle Strategy. It is one of the most conservative investment strategies I manage and compared to an all stock benchmark like the S&P 500, is has experienced an incredibly low correlation of +0.36% over the last few years.  Meaning, approximately 2/3 of the time the strategy does not move in the same direction as the S&P 500. The maximum draw down is approximately ½ the S&P 500 while also capturing approximately ½ the return.  (Statistics courtesy of ETFReplay.com, Last 36 months through July 11, 2018)  I am also able to provide the same data going back to 2009, which looks terrific.

 

 

 

 

Three of the four asset classes in this strategy can be extremely volatile at times.  Yet, more often then not they experience their volatility at different times.  Therefore, as a group they can be less volatile.