April 16, 2019
Calyx Q2 2019 Quarterly Comment
The first quarter brought us “The Big Bounce” – the rebound of the stock market from the lows of last Christmas. While the media has been riveted on the S&P 500 climbing back, the returns of asset classes and industries have been anything but uniform.
In the 4th quarter of last year global markets fell off the table and each day brought more bad news. And then suddenly on the day after Christmas, it all reversed. The same data that was good in October, re-interpreted as bad in early December, was now OK again. This market behavior was similar to early 2018, when the equities surged to new highs only to dropped severely within weeks. The fundamentals hadn’t changed much, but perceptions had. Optimism changed to pessimism and back again, causing greed to become fear and then paralyzing caution.
In 2018 we were aggressive, posting strong gains along with the rest of the market. But later in the year, when our risk systems flashed caution, we reduced positions and moved increasingly into cash, even though the fundamentals never changed. We ended the year even, and for some of our clients still slightly ahead. Other managers were not so fortunate, as last year ALL asset classes lost money. The large investment firms saw their client’s portfolios fall from 12-15% in the 4th quarter, leaving them with losses of 6-10% for the year. Calyx relative returns were meaningfully higher than the majority of other managers, large and small.
During the first months of 2019 the stock market scaled a wall of investor worry while being focused on many things; trade wars, Brexit, and continued corporate earnings. FED policy flip-flopped early in the year as the central bank moved from guarding against an overheated recovery to insuring the continued stock market rally. This change in focus triggered warnings of a global slowdown and recession. Investors began to fear that the recovery was getting tired, that the cycle might be turning. Many worried out loud that if America couldn’t lead the world economy higher, perhaps the rest of the world might drag our economy lower.
Most of “The Big Bounce” in stock prices occurred in the first weeks of the year. During March the stock market was barely up 1% while many sectors and geographies pulled back. At Calyx, we maintained a conservative stance, and in response to the economic data and news took the opportunity to add income-producing equities and ETF’s to our mix.
We agree that the economy may be late in the cycle historically, but the data still does not suggest a recession. Instead, we see a pull-back with corporate earnings struggling to support high stock values. Some stock sectors (including the FAANG tech stocks) are facing headwinds, and the economic health of the rest of the world is a big question mark. We will continue to stay invested and continue to use our risk systems to guide us.
Spring time has finally arrived here in New Jersey. Easter comes late this year and the trees are only now beginning to bud, the lawns are showing some green, and the weather getting a little warmer. It’s been a long winter and we’ve been looking forward to this spring.
Those who are immersed in the financial markets had a tough Christmas and New Year’s. Last December, the global markets fell off of the table, producing quick and severe pain for even the most seasoned portfolio manager. The downturn seemed to be only one way, with no respite from bad news. Each day the damage was swift and brutal and there was no pause to consider options or a small rebound to get out. The markets just kept falling.
It came out of the blue. Just two months before everything seemed perfect. At the end of September, the stock market was trading to its all-time highs, a US tax cut was helping corporate profits, and inflation was low… in spite of record employment and rising wages. With a pro-business president in the White House, America was in the process of remaking the world’s trade structure and leading a global recovery. Interest rates at unbelievably low levels encouraged businesses and individuals to take risks, grow, and spend.
But then it hit… the doubt, the second guessing, could all of this good news continue forever? First the Federal Reserve bank announced that things were going so well that there might be an opportunity to raise interest rates a notch or two. Europe’s bankers made similar noise, only to quickly step back when it became apparent that the European recovery wasn’t quite as robust as the US, especially with Brexit getting closer. Then the November US congressional elections put the Democrats in control of the House promising to investigate and impeach. Suddenly the mood changed.
China stiffened during trade talks with the US and the swift renegotiation the markets hoped for suddenly looked more like a long, drawn out trade war. The trade spat became the trade war that might derail global recovery. Oil dropped on fears of a global slowdown and the slowdown became very real. Markets that had just weeks before looked like they could go up forever suddenly seemed overbought, with institutional traders, pension funds, hedge funds, and retail investors all caught long the market.
Have a look at the chart on the next page and trace the severity of the sell-off in December. It wasn’t a panic, but it was close. The most distressing part was that the good news really hadn’t changed. What had changed was perception.
The intangible fuel of the two-year rally was an optimism that now suddenly became pessimism. Events that only weeks before been viewed as positive were now a challenge, fears that were brushed aside were now insurmountable. The stock markets had the worse Christmas Eve ever, falling almost 3%. It was a very tough Holiday.
The day after Christmas, the 26th, something extraordinary happened. All was forgotten and the markets rebounded almost 5%, recovering the Christmas Eve losses, and then some. Oversold prices quickly corrected themselves as the sentiment turned from pessimistic to opportunistic. The bargain hunters entered the market and the rally was on.
For Calyx, the strong profits we managed to generate during 2018, especially in the 3rd quarter, vanished in the year end sell-off. Our risk systems saved us, however, by directing us to reduce positions and move increasingly into cash. We ended the year even, and for some of our clients still slightly ahead for the year. Other firms were not so fortunate. The large investment houses saw their client’s portfolios fall anywhere from 12-15% in the 4th quarter.
As you can read from the chart above, January started off with some doubt. The first few trading days were an emotional roller coaster as the market sorted out fact from emotion, data from sentiment. What was really driving things? Rising interest rates and oil prices seemed to be both the cause and the effect of the December sell-off. Strong employment figures and rising wages were certainly good news, but inflation fears underlined the data. The China trade negotiations were a time to remake some very old and one-sided trade agreements, but US dependency on Chinese manufacturing and Chinese purchases of our Treasury debt make it difficult to take a tough stance.
The bounce didn’t happen all at once, it came in fits and starts. And this time there were different players leading the way. Throughout 2018 technology stocks, particularly the FAANG’s, carried the rally. Healthcare was a big factor, but technology powered the growth of the market. With very low interest rates there was little incentive to invest in fixed income or dividend plays, so growth was the game. In 2019, its different. Technology and HealthCare have had a rougher time. Financials have been difficult given low interest rates make lending less profitable. As markets continued their recovery through the first quarter the Federal Reserve announced an accommodative policy that implied interest rates will remain low. There have been moments when the market commentary returned to fears of a global slowdown, or even recession, but those fears seem to be based on the length of the rally and less about the economy. For now, all seems clear.
Trade negotiations with China have continued, and now seem on-track for a comprehensive agreement covering not only imports and exports, but also technology transfer protection for US patents, increased access to Chinese markets for US goods and services, and Chinese commitment to purchase US agricultural products. These concessions would be in recognition to the present lopsided relationship, where China dominates in manufacturing and imports into the US. The resolution of the US Chinese trade war would bring significant tariff reductions on both sides and perhaps even the elimination of punitive trade taxes.
At Calyx we adopted a less aggressive approach, relying on some fixed income ETF’s and interest proxies to bring in consistent return. We’ve found a few dividends and believe energy and commodities may be in for appreciation. We’ve reduced broad market exposure in both the US and abroad and have pulled back from growth technologies.
In the end, we finished the 1st quarter within sight of those all-time highs we set last September. The Bounce has brought us almost full circle, with the rally offering relief and hope after the previous quarter’s correction.
Of course, the big question now is “Where do we go from here?”
Most signs seem to point to a continued strong economy, albeit with slightly softer growth. Continued strength will provoke an interest rate hike, and the market will look for signals from an accommodative Fed that these hikes won’t come too fast or too far.
At Calyx we believe that the market will require a compelling reason to trade higher and will not be content to muddle along with benign good news. In the last quarter of 2018 the market capitulated on a swift change in sentiment, even in the face of good news. Likewise, we fear a market that only goes up, particularly when there doesn’t seem to be any reason to be concerned. “It’s all good” often ends badly, so we remain cautious.
We sometimes remind our clients of what we do and how it is different.
When the market is rocking and rolling, as it has been for the last several years, client’s concerns about risk diminish because strong annual returns feel good. However, towards the end of an investment cycle, our Calyx selective asset and risk management approach can mean the difference between having money to fund retirement or not. Many people lost 50% of their portfolios in 2008 and it took many of them over 10 years to recoup those losses.
Last year, clients of large firm’s lost 6-10%. Calyx avoided losses for our clients, and in some cases showing small positive returns. Our returns were 5%-9% points higher when compared to retail accounts at most managers.
After almost three years, Great Britain’s Brexit drama has entered a new phase. The most recent delay to Britain’s departure from the European Union, granted by the EU in the last few days, takes the major risk of a “hard Brexit” departure from the EU, with no trade concessions, off the table.
The recent EU agreement to delay the Brexit deadline until October 31 removed language from earlier drafts that ruled out further extensions, effectively making this extension open-ended. European Council President Donald Tusk also signaled flexibility should the October deadline prove insufficient.
A likely outcome may be “Brexit in name-only” with continued UK membership in the EU single market or customs union and a multi-year negotiation toward a UK-EU free trade agreement. A Tory-Labor BREXIT deal to find compromise in Parliament might be subject to a confirmatory popular referendum, essentially posing the BREXIT question to the electorate a second time, seeking a different answer from the first.
The risk of a “no-deal” or “hard Brexit” now seems very unlikely. No one in the UK government really wants an outcome that would have been so disruptive for businesses and the general population and the EU.
The housing market touches all of us. Whether we own or rent, we are affected by interest rates and property values. For homeowners, often the biggest portion of our wealth is our homes, affording us a chance to borrow against it and hopefully benefit from its appreciation. Recent years have seen that equation turned upside down, with some homeowners caught up in “negative equity” where the debt on their home is larger than its value.
The current level of home lending defaults has been running at the same pace for the past 6-7 years. This may be OK, but if/when economic conditions deteriorate, we may expect problems on almost ½ of mortgage loans outstanding.
These potential problems are because medium and higher priced homes, which have stronger borrowers and larger down payments, have reduced their percentage of sales. Today a larger percentage of buyers are first-time, aided by looser lending criteria similar to before the 2008 housing collapse. Changes in the housing market, where more expensive homes sales and prices have been falling, and smaller home prices and sales are increasing depict a significant generational shift as younger buyers enter the market. Sales in larger metro areas have declined while sales in small cities and towns are growing, indicating a possible cultural shift.
The Federal Budget
We all worry about taxes and how much the government spends. Presidents and Congresses nudge and steer the budget, but change comes slowly and subtly. While each administration has its own priorities and programs, a bureaucracy the size of the US Federal government has a life and direction of its own.
For years, successive administrations have “kicked the can down the road”, unwilling to make decisions on taxes and spending that might bring us closer to a balanced budget. This is a financial timebomb that will affect us all someday.
2020 Federal Government Budget
Total Budget $4.746 Billion
Tax Revenues $3.645 Billion
Deficit $1.101 Billion
Taxes only cover 75% of the budget, we borrow the rest.
Military spending is 21% of the budget, multiples of what others spend.
Government Agency costs and Foreign Aid are minor budget items.
Interest on the Federal Debt is 10% of the total Budget
Washington DC govt. operations (minus the military) are 9% of the budget
Where does the money come from?
Income Taxes $1,824 Billion 38%
SS & Med payroll $1,295 Billion 27%
Corporate Taxes $ 255 Billion 5%
Tariffs / Excise $157 Billion 3%
Other $114 Billion 2%
Borrowing $1,101 Billion 25%
How do Social programs add up?
$1,102 Billion Retirement/ Social Security & Fed. Govt.
$642 Billion Welfare programs
$1,097 Billion Medical care – Medicare & Medicaid
$2,841 Billion Total
Mandatory social programs account for 60% of the budget.
Medicaid, Medicare and Obamacare are part of the budget.
Social Security is covered by its own taxes and is not part of the budget.
Clients see the hype surrounding an IPO (Initial Public Offering) of a familiar name and sometimes ask about them. The media reports on the huge payoffs IPO’s afford, but in the end not all IPO’s turn out well. A review of 7,713 IPO’s over the last 36 years proves the compelling power of a good story.
50% lost money
30% made money, with the average being below 8%.
16% made between 100% and 500% - an annualized return of between 20% and 100%
4% gained over 500%
The Wall of Worry
“The Wall of Worry” refers to the skepticism of financial markets, in the face of positive economic and corporate news. For the past 3 months, the 1st quarter Bounce that we talked about earlier in this note climbed this “Wall of Worry” as stocks advanced in the face of the China trade war, the President’s criticism of the Fed, fears of a global slowdown, and looming recession. Disregarding the Wall and going all-in with high risk investments would have garnered a nice double-digit return, but it has been a different, more selective rally this year. None of the cyclical or growth leaders of 2018 have returned to their peaks of last year. For Technology, Defense, Financials, Consumer Goods, and Manufacturers, the strong gains so far this year were a fraction of the double-digit declines in late 2018. Over the past 6 months “risk” investments are still under water.
In the current market, true price-growth has occurred elsewhere: Health Technology, Utilities, REITs, Corporate Bonds & High Yield bonds and Treasuries. ALL of these are trading above last year’s levels. All of these (except health tech) provide cash flow and are perceived to be “safe” investments in a storm. Health providers and insurers would normally have been included in this list if they weren’t in play politically.
For the market to maintain its momentum there are two factors to watch:
profit levels need to stay strong in the face of declining forecasts
price/earnings ratios remaining well above the longer-term market average
Right now, the market is factoring in stable to higher earnings, and an expanding PE ratio from the December levels. Is this situation sustainable? We’re not sure. As we said earlier, we are looking for a reason for the rally to continue, a compelling story that will help to maintain the markets momentum and give investors a goal.
Ed, Branson and Claudia
At Calyx, we help families protect and manage their financial resources. We are a financial advisor and investment manager that partners with our clients to administer their financial affairs with personal attention and active risk management.
Calyx is also advisor to charitable trusts and endowments, working with committees of faith-based organizations to preserve their legacy while providing operating income. We are sensitive to the investment needs of these clients while working within the guidelines they have established to reflect their principles.