a steadily rising Fed Funds rate into 2019

That’s the thrust of Fed Chair Janet Yellen’s remarks yesterday about rates in the US.

She said that there would be “a few” increases in the Fed Funds rate in each of 2017 and 2018.  Assuming that a few = three and that each increase will be 0.25%, Yellen’s statement implies that the rate will rise steadily until it reaches 2.0% sometime next year.

In one sense, two years of rising interest rates sounds like a lot–I know that’s what I thought the first time I was facing this prospect as a portfolio manager.  But if the neutral target rate for overnight money is the level that achieves inflation protection but no real return, 2% should be the target.  If anything, it’s a bare minimum.

In my view, two surprises to the Yellen forecast are possible:

–if President Trump is able to launch a significant fiscal stimulus program, the rate rise timetable will likely be accelerated, and

–if the inflation rate rises above 2%, which I think is a good possibility, then the Fed Funds rate may need to rise above 2% (2.5%?) to keep inflation in check.

Typically, a time of rising rates is one in which stocks–buoyed by increasing corporate earnings–go sideways, while bonds go down.  In the present case, earnings growth will likely depend on an end to dysfunction in Washington.



reading a financial newspaper

Early on in my investing career, I came to realize that it’s better to read financial newspapers by starting on the back page and working toward the front.

How so?

As investors, we’re searching for information that is potentially important but not yet well known.  Arguably, the best information won’t yet be in print.  But as it does appear, it will usually come in the form of small articles on the back pages.  Typically, when information is on the front page, or when it appears as a magazine cover, investors normally begin to think hard about adopting the contrary stance.

At first blush, reading from back to front is hard to do with online news services.  Worse,  the order of online news is constantly being curated, meaning that the most popular items are pushed toward the front.  The less well-received–that is, the more interesting for us–are progressively pushed toward the rear.

Interestingly, the Wall Street Journal and the Financial Times both have introduced what is being described as a “new” way of reading the newspaper, a digital form of the print newspaper.  Personally, I prefer the print newspaper.  But I find this digital form just as useful when I’m on the road.

the S&P after the Trump election raly

Taking numbers from Factset, a very reliable source, the S&P 500 is trading at about 17x estimated 2017 earnings.  That’s based on the assumption of slightly more than 10% eps growth from the S&P components this year–a figure I think is reasonable.

This is a potential problem for stock market returns in 2017, since that PE is maybe 12% higher than average for the S&P 500 index over the recent past.  And, of course, interest rates will likely be rising throughout this year and beyond.

Arguably, the elevated PE means that the sharp rally in stock markets since the Trump election has already factored into today’s prices everything positive that Mr Trump is likely to get done during the next 12 months.

That’s the safest assumption.  Concluding that doesn’t imply that there’s no money to be made in stocks in 2107, however.  Instead, it suggests that sector and stock selection will be the only money-making game in town.

Also–and this may simply be my inherently bullish nature taking over–that assumption may be too conservative.  It seems to me an important characteristic of fundamental changes in market direction is that they’re not driven by changes in consensus earnings.  Rather, the market tends to move considerably in advance of changing earnings.

We see this most often as the business cycle waxes and wanes.  At the bottom (top) of the cycle, when the Fed signals that it is going to lower (raise) interest rates, there’s an immediate, significant change in market direction and tone–even though it will take many months for the new interest rate regime to play out in earnings.  We can also observe this in commodity price-driven industries like oil, where stocks react sharply to changes in spot prices.  Oilfield services firms are especially instructive in this regard, since their stock prices tend to react in a high-beta way to oil price changes even though the firms may have long-term, fixed-price service contracts.  That’s because experienced investors realize that when an oil major simply returns a drilling rig to a service company and says it will no longer pay, there’s little that can be done   …if the services firm expects to have any business during the next upturn.


It seems to me that the S&P is now anticipating a similar kind of (favorable) economic step change during the early years of a Trump administration.   I see no reason to bet against this outcome.  This has little to do with Mr. Trump’s obvious flaws; it’s mostly because the electorate has put power decisively into the hands of one party.  If I’m correct, I’d expect the market to move sideways until we get evidence in legislation that substantial fiscal stimulus is under way.  Assuming this occurs, the second half of 2017 will likely be substantially better than the consensus now expects.

Of course, one has to keep the potential for downside clearly in mind.  My biggest worry:  my reading of his business career is that Mr. Trump has saved himself from his substantial bet-the-farm misjudgments (think:  Atlantic City casinos) mostly by throwing his partners under the bus.  In the present case, that’s you and me.



January and the Trump rally

The first couple of weeks in January are usually bad ones for stocks.  Taxable investors typically start their annual portfolio revamping by selling their losers near yearend but they tend to nurse their winners into the following tax year.  From the first trading day in January on, they aggressively prune or jettison profitable positions they no longer think will outperform.

As a result, stocks usually go down in early January.

(An aside:  December losers, especially small caps selling for below $5 a share, tend to bounce back sharply from late-year lows in January.  This is called the “January effect.”  I don’t think it will play an important role this year.)

Not so, so far in 2017.  Instead, the upward movement in the S&P 500 triggered by the surprise election of Donald Trump as president has continued.

Two key differences between today and the last two months of 2016:

–the US$ has, at least for the moment, stopped rising, and

–the market seems to be rotating away from putative Trump administration beneficiaries into left-behind sectors like IT and REITs.

What does this mean?

I think it says that the initial rally on the anticipation of possible pluses from an end to dysfunction in Washington–corporate tax reform, infrastructure spending, and a more normal monetary policy–is getting long in the tooth.  Yes, economic growth appears to be accelerating and consumer confidence is rising.  But potential winners from a Trump administration have advanced by, let’s say, 20% since the election, while more defensive issues have fallen.

Investors are shifting from being driven by concept to being motivated by valuation.  They think, correctly in my view, that the leaders are looking a bit pricey and laggards are looking like relative bargains.  So they’re moving from the first group to the second.

What happens next?

Absent new information, or new inflows of money to equity managers, the market is likely to stall and then sag a little.   The most important factor here is the consensus expectation that the S&P 500 is likely to rise by about 5% for the year as a whole–which would imply there’s severely limited upside, at least until we get further concrete information about the economy or about Congress.

My guess is that the next major move is up.  If so, it will be triggered either by surprisingly good economic data or by bold action to stimulate the economy from Congress.  We should be watching carefully for either.

In the meantime, we can deepen our analysis of Trump beneficiaries, especially, I think, in the Energy sector.  My sense is, day traders aside, there’s no reason to sell (of course, I’m bullish by disposition, so this is my default position).





market rotation: two types

market/sector rotation

Market rotation, sometimes also called sector rotation, is a shift in the pattern of sector outperformance in the stock market.  In 2016, for example, the S&P 500 favored defensive sectors over aggressive ones.  2016 produced the opposite result.


The market rotates for two basic reasons:

change in economic circumstances.  In early 2016, for example, Wall Street began to believe that the price of crude oil, which had been in free fall for two years, finally hit bottom at around $26 a barrel.  So oil stocks began doing better.  Similarly, investors now believe that the election of Donald Trump as president, meaning both houses of Congress and the White House are all Republican, signals the end of Washington dysfunction.  This implies a significant turn for the better in the US economy.  As a result, the most economically sensitive areas of the stock market have been doing better since Election Day.

valuation.  Professional investors often say that “trees don’t grow to the sky,” meaning that at some point sectors that are enjoying an economic tailwind become too expensive relative to those being buffeted by temporary headwinds.  At such times, they will begin to buy stocks in left-behind sectors almost entirely on the idea that as financial instruments they are relative bargains.

short/shallow vs. long/deep

Sector rotations based on valuation tend to be much shorter and shallower than those based on a change in economic circumstances.

the 2015 -16 example

In 2015,  the Healthcare sector rose by +5.2% and Energy fell by -23.6%.  The difference in performance between the two was a whopping 28.8 percentage points.

In 2016, Healthcare fell by 4.4% and Energy rose by +23.7%.  The performance difference between the two was 28.1 points.

what about today?

To me, the extent of the outperformance of the most economically sensitive sectors since the election has been so strong as to invite a market rotation away from them.  My guess is that this will be based mostly on relative valuation.  If so, the turn away from current market leaders will be relatively brief and the correction in these sectors relatively shallow.

For day traders, this will be a big deal; for you and me, not so much.  Our main concern will be the buying opportunity in cyclicals a correction in them will present.

Shaping a Portfolio for 2017: interest rates and currency

To a great degree, changes in interest rates and changes in currency substitute for each other in an overall macroeconomic sense.  A rise in the world value of the US$ is equivalent to an increase in interest rates, in that both act to slow down overall US growth.  A decline in rates or in the dollar acts as stimulus.

What is 2017 likely to bring?

interest rates

Ignoring the mid-year lows, one-month T-bills began 2016 at a 0.17% yield and are now at 0.39%.  The 10-year bond opened the year yielding 2.24% and is closing at 2.46%.  Over the same period, the Federal Reserve has raised the overnight money rate by 0.25%.

My guess is that the Fed will raise the overnight lending rate by at least 0.50% and possibly by 0.75% in 2017.  The latter would likely translate into a rise in the 10-year to something just below 3%, the former to a yield of 2.75% or so.


I think the chances of the larger rate rise are greater if the dollar remains around today’s level.  As I’ve written recently, I think the US stock market is already trading as if long-dated Treasury bonds were yielding 4%–where I think the endpoint of restoring rates to normal will be.  That’s something that probably won’t occur until 2018.

In addition, the US stock market has typically gone sideways during past times of Fed tightening.  What would be unusual this time around would be if Congress follows through on a large, growth-stimulating, public works spending program.  This would, I think, minimize any negative effect rising rates would have on stocks.

effects on the S&P 500

If the past is prologue, the main effect of rising rates and rising currency will be on the relative performance of sectors.

The more interest rates rise, the more attractive bonds will become vs.stocks whose main appeal is their stream of dividend income.  So income stocks would be negatively affected.

The more the US$ rises, the weaker the US$ growth of foreign operations of US multinationals will be.  Import-competing businesses would be hurt as well.  Purely domestic firms would be relatively unaffected.  My guess, however, is that the bulk of the dollar rise on a more functional national government has already occurred.



Shaping a Portfolio for 2017: emerging markets (ii)

Ex China, emerging markets are a motley crew.

MSCI Emerging Markets Index


The MSCI Emerging Markets index consists of 23 countries.  At about 28% of the total, China is the largest component.  After that come, in order, South Korea at 15%, Taiwan at 12%, and India and Brazil at 8% each. The rest average 1.6% apiece.


The biggest sectors are IT and (mostly state-controlled) Financials, at about a quarter of the index each, and Natural Resources at 15%.

individual stocks

The five largest individual components of the index, comprising 15% of the total are, again in order:  Samsung Electronics, TSMC, Tencent, Alibaba and China Mobile.  All of these can be bought as individual stocks either in Hong Kong or in the US.

my take

To my mind, the most foreign investor-friendly country of the bunch is mainland China.  The rest are either not open to foreigners or are subject to the heavy hand of government control.  A big virtue of the index is that we can obtain exposure to 22 problematic places for foreigners to invest in one package and in a highly liquid form.

The big question is whether we want this exposure or not.  The merits of individual countries/securities aside, this has typically been a good thing when the world economy is expanding rapidly and when trade is in a high-beta relationship with overall growth (as it has been throughout almost all my investing career).  It has typically been a bad thing when the world is in recession.

At present, I don’t see the positive case as particularly compelling.  In addition, the high-beta relationship between trade and growth which has worked to the benefit of emerging nations for decades has been showing recent signs of breaking down.  So it’s at least thinkable that the payoff from taking the risk of investing in the more frontier-ish of these countries will be less than in the past.  Personally, I’d prefer to own developed markets + China right now.