Shaping a Portfolio for 2017: the US

For the first time in ages, the US economy is pretty straightforward to analyze.  The US stock market, on the other hand, has many more twists and turns than usual.  Happily for me, the economy is today’s topic.

all macroeconomic plusses

From a strictly macroeconomic view, it’s all plusses:

–the economy is at full employment

–the US is growing at close to its long-term potential of 2% a year.  It may have a somewhat faster spurt in 2017

–inflation is under control

–consumer spending is strong

–business capital spending is beginning to accelerate

–corporate tax reform may make domestic-oriented businesses more profitable

–badly needed infrastructure spending, blocked by Republicans because Mr. Obama was in office, will likely be begun once Mr. Trump is inaugurated.  While this may not seem fair,  it’s reality

–having expansionary fiscal policy in play will allow the Fed to raise interest rates faster than it otherwise would (even the most ardent supporters of the primacy of monetary policy were beginning to realize that eight years in interest-rate intensive care is not healthy)

–the US$ is rising; demand for government debt–which offers foreigners an above average yield + the possibility of  currency gain–is strong.  Demand from American citizens will likely improve as coupon yields rise.

broad stock market implications

To sum up, the US economy will likely expand in 2017 by, let’s say, 2.5% – 3.0%.  Add in 2% inflation and the result is, on the high side, 5% nominal growth.  If we observe that the S&P 500 contains the best and brightest of the US, earnings for the S&P could rise by 10% in 2017.  The absolute earnings number could also get a big one-time boost from a lowering of the corporate tax rate.

tax reform earnings gains:  how big?

My back-of-the-envelope guess:  half the net earnings of the S&P come from the US.  Let’s hypothesize (i.e., make up a number) that half of that figure is fully taxed.

(An aside:  if I were still working, I’d either ask a junior person to go through a database–or 500 annual reports–and figure the number out or call a brokerage house that surely has already done the grunt work.)

Let’s also say that the top Federal tax rate is also cut in half.  This would imply something like a 12.5% boost to the level of S&P 500 earnings from the fully taxed half + probably a much smaller number from the other half.  Even if this doesn’t turn out to be uncannily accurate, we can assume that the boost to earnings could  be more than 10% and less than 20%.  So +15% sounds good to me.


One complication:  oil.  Accounting for natural resources is weird, and hard to figure from the outside, no matter what the circumstances.

Oil exploration operations may decide to have throw in the kitchen sink-style writeoffs of projects that are unprofitable at current oil prices.  It’s certainly what I’d do. That might make 2016 income statements for the oils as ugly as 2015 ones were.  But, with potential losses jettisoned, 2017 numbers would likely turn out to be surprisingly good.



Shaping a Portfolio for 2017: a look back at 2016

The first step in formulating an investment strategy for the coming year is to check back to see how well you did in forecasting what would be happening in the current year.

Here goes.

I thought that the best economy in the investable would be the US, that the EU would begin to rebound from a poor 2015 and that the emerging/frontier markets should be avoided.  Ok so far.

I thought that eps growth in the US would be +6% – +7%, that interest rates would remain ultra-low, that PE multiples would neither expand nor contract, and that individual stock selection, rather than industry or sector selection, would be the key to success.   Mostly ok.


Actually, if the year had ended on November 1st, my year-ago thoughts would have turned out to be pretty accurate.  Yes, I didn’t foresee that Britain would vote to leave the EU, but of course that referendum didn’t need to be called in 2016 and the June date for voting was only set in February 2016.  And I didn’t anticipate the January-February market swoon that started the year off.  That doesn’t bother me so much, either.

So until the approach of Election Day, I was doing about as well as anyone would have a right to expect.  The S&P was up 4% for the year on Halloween–vs. my +6% – +7% for the full year.  Interest rates remained ultra-low.  It appeared a colorless candidate favoring maintaining the status quo would (barely) beat a tacky reality show star, a political neophyte radiating bigotry and trailing a cloud of dubious business dealings, in the race for president.

Then Donald Trump won the election.

Since then, +4% on the S&P has become +11%.  The US$ has risen sharply.  Stock picking has become less important than sector selection–favoring energy, industrials, materials, that is, the areas that benefit the most from accelerating economic growth.  Tech and dividend stocks have been on the outside looking in.  The promise of large-scale infrastructure spending suggests the Fed will be free to raise interest rates next year at a faster pace than I imagined possible.  Rates have, of course, already been going up in anticipation of Fed action.

As a result, the A I would have awarded myself two months ago is probably now a B.






a post-election scoreboard: day one of outlining a strategy for 2017

Financial markets around the world have been remarkably active since the improbable election of Donald Trump as the next president of the United States.

  1.  The S&P 500 has risen by 5.8%
  2. The dollar has risen by 5.6% against the euro
  3. The dollar has risen an amazing 13.5% against the yen
  4.  The Eurostoxx 50 has gained 7.0%, meaning US$ investors have a loss of about 1.5% from holding large-cap Euroland shares
  5. The Nikkei 225 is up by 11.4%, meaning US$ investors have a loss of about 2% from investing in Japanese stocks.

These are all big moves.

To my mind, in the US the correct way to interpret them is this:   Wall Street believes paralysis in Washington is at an end and that resulting fiscal stimulus will allow the Fed to raise interest rates from their current extraordinary lows.  Put it another way, the focus of treatment for the economy will be away from life support and toward a return to health.  The enhanced potential for future earnings growth is generating both upward stock movement and higher interest rates.  The latter is causing the dollar to rise.

For the rest of the world, I think, a different, more derivative, dynamic is at work.  If investors are looking to the US as the locomotive that will pull Japan and the EU out of their current malaise, I think that’s a secondary effect.  I think the rise in those markets is being driven by the spur to their export-oriented industries given to them by the  precipitous falls in their currencies.

(An aside:  there’s a certain irony in having the professed (but looney-tunes, in my view) Trump agenda of bringing low-wage low-skill jobs back from developing economies having been so immediately, and deeply, undermined by post-election currency movements.)

What to make of all this?

I interpret what’s happening as the start of a very traditional stock market pattern.   When an economic upturn is beginning,  commodities-related industries react in an anticipatory way to expected future events and then move more or less sideways until there’s clear evidence in earnings that the anticipation is correct.  Earnings gains create a second, earnings-based upward movement.

Put a slightly different way, the market moves from having a bad future priced in to a neutral position.  It then reacts to good things as and when they begin to occur.

A third formulation: the post-election move is akin to the beginning of a business-cycle driven bull market.  That’s a little strong, since I don’t think the typical 30% gains of a bull market are in store for us over the next couple of years.

But I do believe we should be thinking aggressively, not defensively.

What would change my mind, or at least cause me to rethink?  …weakness in the US$, or some sign that the new administration has no intention of carrying out its agenda of breaking with business as usual in Washington.

More tomorrow.





casino gambling in Japan

Last week the Japanese Diet approved the creation of the first Las Vegas-style casinos in Japan.  Most Japanese citizens appear to be indifferent, but introducing a new form of legal gambling has been a priority for the political establishment for some time.  Although the standard rationale for legalizing gambling anywhere in the world is to take money away from the local underworld, the main reason in Tokyo seems to be to attract more foreign tourists–and keep them in Japan longer.

It will be a while before gambling consortia of construction companies and resort developers, presumably with foreign partners providing the expertise, are formed and for the precise rules about allowed games and taxation to be articulated.  But two issues are already clear:

–over the past ten years or so, there has been a dramatic expansion of the casino business in Macau, as well as in Singapore/Malaysia, the Philippines, Korea and, to a lesser extent, in Australia.  At some point, the market in this part of the world will become saturated.  Then, the fact of gambling won’t be enough.  The quality of the operations will count for a lot more.  So I don’t think Japanese casinos are sure-fire winners.  We have seen this already in Macau, where SJM, once the monopoly operator, continues to lose market share.  Will Japan push the region as a whole into maturity?

–who will run the casinos?  Presumably Wynn, Las Vegas Sands and Galaxy Entertainment will all be interested.  My guess is that groups including each of the three will be the key contenders for licenses.  Will each get a license?  Will that be a good thing?  Will Wynn Macau and Sands China be involved?  Certainly, Galaxy will be, since the Macau operations and the main company are the same.  In the other cases, it’s not so clear.  If investment capital were no object, my guess would be no.

traditional pension plans in the US: trouble (ii)


The California Public Employees’ Retirement System (CalPERS) is a bellwether for government employee pension plans around the US.

not fully funded

By its own calculations, CalPERS is not fully funded, meaning that it does not have enough money on hand today to meet the future pension obligations of its members.  That’s even assuming, as it officially does at the moment, that it can earn on average 7.5% on its investments yearly.

assuming a 7.5% annual return

How reasonable is it, though, to think that CalPERS–or anyone else in a similar situation–can earn 7.5% on a diversified portfolio of stocks and bonds?


Let’s assume an asset allocation of 50% stocks and 50% bonds, just to make the arithmetic simple.

bonds first.  Let’s say that the yield on Treasure bonds rises to 4% over the next several years and stays steady at that level from that point on.  When we’re there, CalPERS can earn the coupon each year by holding them, or 4%.  A 4% return on half the portfolio is a contribution of 2% to the entire portfolio   Note:  we already know that the return will be less than that over the time it takes for interest rates rise back to normal.

stocks.  To achieve a 7.5% return on the entire portfolio, assuming bonds deliver 2%, stocks will have to chip in 5.5% per year to the total.  This means achieving an average 11% annual return on the stock half.  How reasonable is this?  Well, over the past ten years the S&P has risen by 58%, or on average by a little less than 5% per year.  If we assume that inflation will remain contained at around 2%, an 11% return would be a whopping 9% real annual return.  Over long periods of time, stock markets around the world have averaged at best a 6% real annual return.

change the asset allocation?

Yes, we could up the overall return by shifting the asset allocation away from bonds and toward stocks.  But the stock portion would have to be above 90%–making calPERS’ assets vulnerable to wide business cycle swings in their value–before it could achieve a 7.5% annual return, assuming a 6% real return on stocks.

In short, the numbers don’t add up.  The biggest issue isn’t CalPERS’ ability, or lack of it, to manage money well.  It’s that the actuarial assumption of future returns is too high.

Over the recent decade or more, pension plans like CalPERS have tried the “magic” solution of alternative investments–hedge funds and private equity–to try to square the circle.  But most hedge funds continually produce returns to clients that are below the S&P 500.  And, again, the allocation to such dubious, and illiquid, vehicles has got to be very large to move the total return needle, even if one believed the promoters’ marketing claims.

changing the actuarial assumption

Interestingly, California has just announced that it is going to accelerate the process of lowering the assumed return on CalPERS investments to what sounds like a target of 6.5%.  To me, this is clearly the right thing to do, and the sooner the better.  But it will also show that CalPERS is more deeply underfunded than today’s official figures suggest.  It will likely mean that state and local governments will have to up their contributions to the fund.

That’s doable for California.  But what about the country’s government pension fund basket cases, like Illinois and New Jersey?  Following suit will show voters for the first timethe reality of how bad the situation is there.