I’ve just updated my Keeping Score page for a surprisingly strong (to me, anyway) July. Sector rotation is the main message.
As far as US stock are concerned, I don’t know.
As/when the correction is over, however, it’s very important to look for signs of a leadership change. At a minimum, one former hot industry/sector typically grows ice cold; at least one former laggard heats up. Figuring this out and tweaking/reorienting your portfolio can make a big difference in this year’s returns.
There are two factors involved:
—behavior of bank managements: To a considerable degree, commercial banks are able to use changes in interest rates to their money-making advantage. When rates are declining, banks immediately lower the interest they pay for deposits but they keep the rates they charge to borrowers high for as long as they can.
When rates are rising, as is the case in the current economic environment, banks do the opposite. To the degree they can, and given that most loans are variable-rate that is considerable, they raise rates to borrowers immediately. But they keep the interest rate they pay for deposits low for as long as they can.
A generation ago, banks had a much greater ability than they do now to maneuver the interest rate spread. That’s because money market funds were in their infancy. There were no junk bonds to serve as substitutes for commercial loans. There was even a Federal Reserve rule, Regulation Q, that prevented banks from paying interest on checking accounts and put a (low) cap on what they could pay to holders of savings accounts.
Nevertheless, especially as rates are rising, spreads still can widen a lot.
—economic circumstances: bank lending business tends to tail off in recession, since most companies don’t want to take the risk of increasing their debt burden during bad times–even if the potential rewards seem enticing. The credit quality of existing loans also worsens as demand for capital and consumer goods flags.
The opposite happens during recovery. The quality of the loan book improves and customers begin to take on new loans.
stock market effects
The market tends to begin to favor banks as soon as it senses that interest rates are about to rise. Wall Street was helped along this time around when perma-bear bank analyst Mike Mayo turned positive on the group for the first time in ages last summer.
After the anticipatory move, banks have a second leg up when the extent of their actual earnings gains becomes clear. It seems to me the first move has already come to an end …but the second is still ahead of us.
Investment companies are required to file lists of their holdings with the SEC at the end of each quarter. The latest such 13-F form for Berkshire Hathaway shows a buildup in Apple and airlines …and the sale of virtually all of Buffett’s long-term holding in WMT.
WMT as icon
A powerhouse in the 1970s and 1980s, WMT has been a bad stock for a long time. It had a moment in the sun during the market meltdown from mid-2007 through early 2009, when it rose by about 1% while the S&P 500 was almost cut in half. Since the bottom, however, WMT has gained 40% while the S&P is up by 219%.
Wal-Mart isn’t an obviously badly run company. It isn’t, say, Sears, or the Ackman-run J C Penney. But it does have a number of impediments to achieving significant growth in earnings. One is its already gigantic size. A second is its focus on less affluent rural customers who were disproportionately hard-hit by recession and who have in many instances yet to recover. There’s increased competition from the dollar stores. And there’s Amazon, whose competitive threat WMT itself admits it played down for far too long.
—old habits die hard. Mr. Buffett built his career from the 1950s onward on the observation, novel at that time, that traditional Graham/Dodd portfolio investing techniques glossed over the considerable value of investment in intangible assets–brand names, distribution networks, superior business practices. However, by the time I entered the business in the late 1970s, other people–me included–were beginning to adopt his methods. So thinking about intangibles became part of the toolkit, rather than something special. Then, of course, the internet began to erode the power of intangibles to stop newcomers from entering a business. Mr. Buffett, like any successful incumbent (including WMT), has been slow to adapt.
—WMT as metaphor for today. WMT could become more profitable quickly if its heartland lower-income customer base could earn more money. One way to do that would be to bar imported goods from the country, with an eye to creating manufacturing jobs in the US. Of course, that would also destroy the WMT value proposition in the process. So rolling the clock back to 1950 isn’t the answer, either for the health of WMT or for its customers.
Yesterday, TSLA shares touched $260 early in the day. That’s the latest high for a stock that has gained 30% since mid-December, a period during which the S&P advanced by 1.8%.
What does this mean?
–On a personal note, it means I don’t own any more TSLA. Regular readers might reall that one of my sons and I have been trading TSLA between $180-$200 and $250-$260 for the past couple of years. I had sold some at $250 this time around and placed a limit order for the remainder at $260 about a week ago. Yesterday, the stock touched $260.00 for a brief period before falling back to close at $257.48. (An aside: I find it strange that the stock peaked at such a round number. I presume this means there’s a lot of stock on traders’ books waiting to be sold in mechanical fashion–meaning with no attempt to entice buyers higher–at $260.)
–The main message, though, is that there’s a lot more going on in the US stock market than the post-election Trump rally–which seems to me to have already exhausted itself anyway.
I’m driving a Kia Sorrento these days, after my Hyundai Veracruz gave up the ghost late last year. I can imagine my next car being a Tesla. Nevertheless, TSLA is to my mind the ultimate concept stock. Yes, the merger with SolarCity is behind it and the death of a driver using the Tesla self-driving feature seems to have been operator error rather than a flaw in the car. Those are plusses. On the other hand, the company is still struggling with cash flow breakeven. And the Wall Street consensus, for what that’s worth, is that it will lose $1 a share in 2017. So finances continue to be a serious risk. To my mind, the rally is all about the hoped-for success of the Gigafactory, Musk’s reimagining the car manufacturing process, and the triumph of software over hardware and batteries over fossil fuel. TSLA’s gains are a testimony to the rude health of the stock market, with or without a Trump tailwind.
–Areas of interest other than aspirational tech or hoped-for tax reform and infrastructure spending? What about Millennials worldwide? economic strength in the EU? regular old tech? Mexico?? (I haven’t held Mexican stocks for over twenty years, although I’ve had exposure from time to time to that economy through multinationals. I think it’s too early to make a major commitment, but not too soon to be fact-finding.)
The Wall Street Journal has been reporting recently on a problem with the pension plan of a Brooklyn food coop.
The story, in brief, is this:
The coop’s pension fund for around 90 salaried employees has been managed by a coop trustee who is, or has been, employed on Wall Street. The “strategy” was to keep a large cash balance and invest rest of the pension money in eight individual stocks, mostly early-stage biotech firms, one of which the Journal says the manager is also the largest shareholder of.
This is crazy.
The inappropriateness of a highly concentrated strategy and of management by someone other than a third-party expert surfaced last June. Over the prior 12 months, the S&P 500 had been up slightly. The coop was down by 20%, and the $4.8 million fund was underfunded by 40%. As luck would have it, one of the fund’s holdings hit it big during the second half, eliminating the underfunding and allowing the fund to adopt a more conventional strategy without a lot of financial pain.
Although the story notes that Wall Streeters had their fingers in the pension pie, there’s no mention that any of the parties had experience or training in portfolio management in general or the management of pension funds in particular. My guess is that’s because none of them did. They figured that because they had, or once had, business cards from a financial firm, that was all they needed.
My experience is that with small employers like this coop this sort of thing happens all the time. One exception, though: the part about one holding doubling in price, bailing out the whole ill thought out enterprise, usually doesn’t happen. The ending is typically much uglier.
I think corporate tax reform is potentially the most significant item on the Trump administration agenda, as far as US stocks are concerned.
The Trump plan appears to have two parts:
–reduce the top corporate tax rate from 35% to, say, 20%. For a firm that has 100% of its income in the US and which has no substantial current tax breaks, reducing the corporate tax rate would mean a one-time 23% increase in after-tax profit.
–eliminate foreign tax reduction devices. American multinationals, facing high domestic corporate taxation, have resorted to two general types of tax avoidance devices. They have: (1) transferred intellectual property (brand names, patents…) to low-tax foreign jurisdictions like Ireland, and (2) located distribution subsidiaries in similar places. Hong Kong, where the income tax on profits generated by foreign companies is zero, is a favorite.
How this structure works: a US-based multinational uses a Hong Kong subsidiary to pay a contract manufacturer in China $150 for a mobile telecom device. The Hong Kong subsidiary sells the device to its US marketing subsidiary for $250. The US company pays the Irish subsidiary a $100 royalty for the use of the firm’s proprietary technology and brand name. It sells the device to a US customer for $600, recognizing, say, a $200 pre-tax profit in the US, and paying $70 in federal income tax. Without Hong Kong and Dublin, the firm would have a pre-tax profit of $400 and pay $140 in tax.
If I understand correctly, President Trump’s intention is to tax this hypothetical multinational on the entire $400 of pre-tax earnings on sales made in the US–no longer allowing cash flow to be syphoned off to foreign tax havens. At a 20% rate, the firm would pay $80 in federal income tax.
The bottom line: while tax reform of the type I think Mr. Trump has in mind might leave large multinationals no worse off than they are today, it would be a significant benefit to small and medium-sized firms, which tend not to have elaborate tax departments and to be much more US-focused. Just as important, it would eliminate the motivation to create offshore profit centers.
As/when the timing of corporate tax reform becomes clearer, I’d expect further rotation on Wall Street away from multinationals and toward domestic-oriented stocks. A quick-and-dirty way of locating beneficiaries–look for corporate tax rates at or near 35%.