the administration, the economy and the stock market

I’m taking off my hat as an American and putting on my hat as an investor for this post.

That is, I’m putting aside questions like whether the Trump agenda forms a coherent whole, whether Mr. Trump understands much/any of what he’s doing, whether Trump is implementing policies whispered in his ear by backers in the shadows–and why congressmen of both parties have been little more than rubber stamps for his proposals.

My main concern is the effect of his economic policies on stocks.

the tax cut

The top corporate tax rate was reduced from 35% to 21% late last year.  In addition, the wealthiest individuals received tax breaks, a continuation of the “trickle down” economics that has been the mainstay of Washington tax policy since the 1980s.

The new 21% rate is about average for the rest of the world.  This suggests that US corporations will no longer see much advantage in reincorporating abroad in low-tax jurisdictions.  The evidence so far is that they are also dismantling the elaborate tax avoidance schemes they have created by holding their intellectual property, and recognizing most of their profits, in foreign low-tax jurisdictions.  (An aside:  this should have a positive effect on the trade deficit since we are now recognizing the value of American IP as part of the cost of goods made by American companies overseas (think: smartphones.)

My view is that this development was fully discounted in share prices last year.

The original idea was that tax reform would also encompass tax simplification–the elimination of at least part of the rats nest of special interest tax breaks that plagues the federal tax code.  It’s conceivable that Mr. Trump could have used his enormous power over the majority Republican Party to achieve this laudable goal.  But he seems to have made no effort to do so.

Two important consequences of this last:

–the tax cut is a beg reduction in government income, meaning that it is a strong stimulus to economic activity.  That would have been extremely useful, say, nine years ago, but at full employment and above-trend growth, it puts the US at risk of overheating.

–who pays for this?  The bill’s proponents claim that the tax cut will pay for itself through higher growth.  The more likely outcome as things stand now, I think, is that Millennials will inherit a country with a least a trillion dollars more in sovereign debt than would otherwise be the case.

One positive consequence of the untimely fiscal stimulus is that it makes room for the Fed to remove its monetary stimulus (it now has rates at least 100 basis points lower than they should be) faster, and with greater confidence that will do no harm.

Two complications:  Mr. Trump has begun to jawbone the Fed not to do this, apparently thinking a supercharged, unstable economy will be to his advantage.  Also, higher rates raise the cost of borrowing to fund a higher government budget deficit + burgeoning government debt.


Tomorrow: the messy trade arena

revisiting (again) value investing

As regular readers will know, I’m a growth stock investor.  That’s even though I spent my first six years as an analyst/portfolio manager using value techniques almost exclusively–and then worked side by side with a motley crew of value investors for a ten-year period after that.

One way of describing the difference between growth and value is that:

–growth investors know when potentially price-moving news will happen (that is, when quarterly earnings are announced) but are less sure what that news will be

–value investors know what the news will be (if they’ve done their job right, they’re holding stocks where the market has already priced in every possible thing that could go wrong.  All they need is one thing to go right).  However, they may have little idea when good news will occur.


Each style has an inherent problem:

–for growth, it’s hard to find rising earnings during an economic downturn

–for value, it’s possible that a long time (say, two years) may pass before any of a portfolio’s diamonds in the rough are discovered by the market.  In that case, the manager will likely be fired before the portfolio pays off.  His/her successor will either reap the rewards of the predecessor or will dismantle the portfolio before any good stuff can occur.


At times, I do buy what I conceive of a value stocks.  Intel when it was $19, trading at 8x – 9x earnings and yielding almost 4% (I’ve since sold most of what I own) is an example.  But deep value investors would scoff at the notion that this is truly value.


For some time, I’ve been maintaining that value investing has lost its appeal in the 21th century.  Two reasons:

–the stronger one is that the shelf life of physical plant, traditional distribution networks and brand names is no longer “forever” in a globalized, Internet-driven world.  So buying companies that are rich in such assets but not making money is much, much riskier today than it used to be.  Such assets can erode in the twinkling of an eye.

–a weaker claim would be that while there are still value names, it’s hard/impossible to fill out a portfolio of, say, 100 of them, which is the traditional value portfolio structure, in today’s world.


I’m rehashing the growth/value debate here because I’m thinking the stronger position isn’t as unassailable as I’ve believed.

More tomorrow.


three steps and a stumble?

That’s the conventional wisdom (read: old wives tale) about Fed rate hikes and the stock market.  The idea is that the market absorbs the first two hikes in any rate rise series as if nothing were going on   …but reacts negatively on the third.

The third in this series of rate hikes will almost certainly come tomorrow.

The problem with this particular old saw is that there’s very little evidence from the past to support it.  Yes, there may be an immediate knee-jerk reaction downward.  But in almost all cases the S&P 500 is higher a year after a third hike than it was on the day of the rate rise.  Sometimes, the S&P has been a lot higher, once in a while a percent or two lower, but there’s no third-hike disaster on record.

Generally speaking, the reason is that rate rises occur as a policy offset to the threat of the runaway inflation that can happen during a too-rapid acceleration in economic growth.  As financial instruments, stocks face downward pressure as higher rates make cash a more attractive investment option.  On the other hand, strong earnings growth exerts contervailing upward pressure on stock prices.  In most cases, the two effects more or less offset one another.  (Bonds are a different story.  With the possible exception of junk bonds, all the pressure is downward.)

Of course, nothing having to do with economics is that simple.  There are always other forces at work.  Usually they don’t matter, however.

In this case, for example:

–I think of a neutral position for the Fed Funds rate as one where holding cash gives protection against inflation and little, if anything, more.  If so, the neutral Fed Funds rate in today’s world should be between 2.5% and 3.0%.  Let’s say 2.75%.  Three-month T-bills yield 0.75% at present.  To get back to neutral, then, we need the Fed Funds rate to be 200 basis points higher than it is now.

I was stunned when an economist explained this to me when I was a starting out portfolio manager.  I simply didn’t believe what she told me, until I went through the past data and verified what she said.  Back then, I was the odd man out.  Given the wholesale layoffs of experienced talent on Wall Street over the past ten years, however, I wonder how many more budding PMs are in the position I was in the mid-1980s.

–the bigger issue, I think, is Washington.  I read the post-election rally as being based on the belief that Mr. Trump has, and will carry out, a mandate to reform corporate taxes and markedly increase infrastructure spending.  The Fed decision to move at faster than a glacial pace in raising interest rates is based to a considerable degree, I think, on the premise that Mr. Trump will get a substantial amount of that done.  If that assumption is incorrect, then future earnings growth will be weaker than the market now imagines and the Fed will revert to its original snail’s pace plan.  That’s probably a negative for stocks …and a positive for bonds.




the post-election stock market

the election

Well, the election is over, although the local outcome is still in doubt in places like Michigan.  Donald Trump will be the next president.

By around midnight last night, as it was becoming apparent that Hillary was going to lose, US stock index futures had dropped by about 5%.  As I’m writing this, they’ve rallied this morning to down around 1.5%, after Trump made a surprisingly conciliatory victory speech.

The dollar is slightly weaker against major currencies, but not by much.  Bonds are rallying.  This may be on a notion that they’re a safe haven; it may also be on the idea that Trump uncertainty makes it more difficult for the Fed to raise interest rates in December (although wage data seem to me a strong indicator that the Fed can’t delay any longer).

us as stock investors

As stock market investors, our job is not to dwell on (be distracted by) Trump’s limitations.  Rather, it’s to try to figure out what a Trump victory means in terms of economic policy, and how that will play out in future company-by-company and sector-by-sector performance.

The key here is not to focus on the many things we don’t know–like how much of his campaign rhetoric Trump actually means–and to try to find areas we can be confident his administration will emphasize.

The course of today’s trading will give us our first clues to what Wall Street is thinking.

My initial take:

Economists I’ve read seem to agree that a fully implemented Trump platform would reduce the level of national GDP substantially.  One estimate is that GDP would be 5% lower than what it would be under the status quo by the end of his second term.  That’s a loss of close to a trillion dollars a year.  If guesses like this are anywhere near correct, they imply that a lot of what Trump has been saying won’t get done.


Increased infrastructure spending is a likely area of Washington emphasis.  Beneficiaries would be makers of construction machinery and materials.

While there may be some direct plays, I think the bigger effects will likely be indirect.  This means consumer spending at mid- to low-end retail in areas where infrastructure projects are initiated.

A second implication is that, finally, fiscal policy may come into play as a means of boosting economic growth.   One consequence would be that the Fed would have greater ability to raise rates–probably an issue for the second half of 2017.

Donald Trump has talked about encouraging use of conventional hydrocarbon fuels.   I don’t think his actions will do much good for high-sulfur coal.  But it may accelerate shale oil and gas drilling, and construction of pipelines to deliver this output to market.  Ultimately, this will result in lower energy prices, not higher, and, I think, the resulting long-term decline of the oil and gas business.  But for the next few years at least, US-oriented oil and gas developers may do very well.

Trump has also said he’ll cut taxes for the wealthy.  If so, this may prolong the real estate boom in coastal cities.


Let’s listen carefully to what today’s trading on Wall Street says to us.







2110 wins again?

missing Alphabet (GOOG)

First, I should point out that in my Keeping Score comment yesterday, I neglected to mention Alphabet (formerly known as Google) among the large-cap tech losers in late April.

With that out of the way…

2110+ off the table

A while ago, I wrote in PSI that I thought the S&P 500 could break out to the upside this earnings reporting cycle from the trading range, roughly 1800 – 2110, in which it has been mired for the past two years or so.

I should have kept my thoughts to myself.

It’s now looking like this won’t happen.  The index touched 2110 on April 20th, but bounced back as sharply as if the line were electrified.

This isn’t the end of the world.  Short-term market sentiment, where I’m a living example of how hard it is to assess, isn’t that high on the list of investor priorities.  It comes after:

–asset allocation, i.e., how much stocks, how much bonds…

–bull market or bear market?

–sector structure of stockholdings, and

–individual stock selection.

All my error in judgment means is that the aggressive edge I was thinking of applying to my portfolio for the next few months won’t get put on.

stock market or market of stocks?

The lengthy sideways movement of the S&P brings up a deeper question, though.   Is it still possible to make significant amounts of money in the market if the overall direction of stocks is sideways?

There are markets in the world, Japan and smaller markets in the EU come to mind, where the main forces affecting stocks are macroeconomic   …where stocks tend to move as a group, where there’s little company vs. company differentiation and where there’s scant investor interest in stock picking.  In such markets, sideways movement of the index means sideways movement of just about every stock.  There the short answer to my question is “No!”

The US, luckily for us, is, still, the polar opposite.  Yes, professional active management is waning and Baby Boomers have become more income-oriented.  But the latter are being gradually replaced by Millennials.  And the slower information flow implied by the loss of buy side and sell side professionals suggests that the deck is becoming stacked more favorably for individuals like you and me.

What a sideways market means for us, however, is that for the time being we won’t make money by being more aggressive.  Outperformance will come from doing more careful research and being more selective.


Active Share, a way of looking at portfolio management (i)

I’ve been reading lately that Europe is in the midst of a regulatory hunt for money managers who profess to be active managers and are charging high fees for this service, while doing nothing of the sort.  Rather, they are “closet” indexers–meaning that their portfolios look, for all intents and purposes, like their benchmark indices.

I can understand the horror EUers must feel at the wealth devastation wrought by European active fund managers, whose performance, both from my experience and the published figures I’ve seen, I regard as far weaker than their US counterparts’ (who admittedly don’t cover themselves in glory).  Being charged high fees for poor outcomes must sting.  On the other hand, the self-aware EU manager must realize that an index fund is the best product he’s capable of producing for his client.  So in a funny sense the closet indexers are doing their clients a favor–except for the fee part.

But that’s not what I want to write about.

Active Share

The tool regulators are using to detect closet indexing is called Active Share (AS).

It’s something I began using to control the risk in my portfolios in the 1980s, while working at TIAA.  The advent of more powerful computers spawned its widespread use in the industry through performance attribution software during the following decade.  But it only earned its capital letters when two Yale academics published an article (“How Active is Your Fund Manager?  A New Concept That Predicts Performance”) about the concept in 2009.

The idea is straightforward.  Find all the positions where the portfolio holds more than the index weighting and total all the “extra” money in those positions (if the manager holds something not in the index, the entire position counts as extra).  Do the analogous thing with positions where the portfolio holds less than the index weighting.  Take the absolute value of both sums, add them together and divide by two.  Calculate the result as a percentage of the total portfolio value.  The result is the portfolio’s AS.

An example:

The index has four stocks, A, B, C and D.  Each has the same 25% weight.

Each portfolio manager has $100 to manage.

Portfolio manager X puts $25 into each stock.  He has an AS of 0.  He’s an index fund.

PM Y puts $26 each into A and B, and $24 each into C and D.  His overweights total $2; the absolute value (minus signs turned into pluses) of his underweights is $2.  His AS is 2%.  He’s a closet indexer.

PM Z puts $30 into A $40 into B, $20 into C and $10 into D.  His overweights total $20;  the absolute value of his underweights is $20.  His AS is 20%.  He’s clearly an active manager.  In the real world of asset management, he’d be regarded as very aggressive.

The Yale researchers conclude that high ASs are a good thing.

More tomorrow.



Shaping a Portfolio for 2016: summing things up

Today I’ll try to put numbers to my guesses about growth around the world next year.  I think the best way to do this is in two steps, first without trying to factor in what I think will be a negative influence from natural resources industries, and then making both economic and stock market adjustments for them in a second round of analysis.

the US

We’re likely to have trend growth in the US next year, meaning a total of +4% expansion, consisting of +2% real and + 2% inflation.  Because publicly traded companies are typically the best and the brightest, this will probably translate into +8% growth in earnings.

Let’s say that Fed interest rate rises have little net effect on growth and that the dollar has peaked (meaning that headwind is gone).  This may be a bit too optimistic.

I’m guessing that, unlike the past couple of years of aggressive share buybacks, we won’t companies retire more shares than to offset the issuance of new ones to employees through stock option plans. Therefore, 8% earnings growth will translate into +8% growth in earnings per share.

Given that half the earnings of the S&P 500 come from the US, this means the domestic contribution to S&P 500 earnings growth will be +4%.

the EU

The EU is maybe two years behind the US in recovery from recession.  But it has clearly turned the corner and will grow in 2016.  It also has the tailwind of substantial currency depreciation behind it, and the strength of Greater China and the US, major export customers.

Europe is also a substantial beneficiary of the fall in energy prices, although that plus is tempered a bit by the weakness of the euro against the dollar.

For all these reasons, the EU will likely enjoy above-trend growth next year.

Let’s say that the EU will expand by +2.5% real, with +1.5% inflation, for a total of +4%.  That probably also translates into +8% growth in profits for S&P subsidiaries located there, and a +8% advance in eps.

Given that 25% of the profits of the S&P 500 come from the EU, this means that region’s contribution to index earnings will be +2%.

emerging markets

Let’s separate emerging markets into Greater China and everyone else.  In broad strokes, the everyone else are natural resources producers, who are in recession and who will make a negative contribution to S&P 500 growth.  The question is how negative the situation will be.  -3%?

On the other hand, I think that mainland China and its direct sphere of economic influence will have a better 2016 than the consensus now expects.  Let’s say +6%.

If we figure that China and the rest are both roughly equal in size, this implies that emerging markets, which account for 25% of the profits of the S&P, will make a positive contribution to growth in earnings, but a negligible one.  Let’s say +0.5%.

the total

My back of the envelope analysis suggests that the growth in S&P 500 profits will come in at +6% – +7%.  next year.  Not a banner result, but still enough to nudge the index ahead.

the price earnings multiple

In what will be a period of rising interest rates, it seems that there can be no cogent argument for PE multiple expansion in 2016.  If anything, multiple contraction should be the order of the day.

On the other hand, the Fed’s intentions have been widely telegraphed for an extremely long time, so it’s equally hard to argue that the market hasn’t already factored into today’s prices a large portion of any negative effect.  In fact, it seems to me that the market PE already incorporates in it all the tightening the Fed is likely to do.  Nevertheless, there’s always someone who hasn’t gotten the memo, so there will be some negative effect, at least initially.

The most prudent assumption, I think, is that Fed tightening will make little difference to the PE.  The contrarian in me says the money-making stance to take is that the PE will rise once the market sees that Fed tightening will only occur very slowly.  But I’m not willing to take that risk.

a market of stocks

If I’m correct, 2016 will be a mildly positive year, where outperformance will come from astute stock selection rather than playing macro trends.

On Monday:  adjusting for natural resources, especially oil.