October 2017 Newsletter

October 2017 Newsletter

RCM Wealth Advisors – Quarterly Newsletter

Q3 2017

 

Current Market Environment

By George Tkaczuk, MD

 

Get ready for a huge surprise!

As the market uptrend continues, get ready for a huge surprise. I am not talking about an October crash. We aren’t in the predicting business, but we do look at the current state of the market, measure sentiment, and money flows, to try to get a pulse of the public’s psychology and expectations from the market. Looking at these factors, we feed them into our model so we can sense what is probable, while at the same time realizing what is possible. Right now, the stage is set for a continued uptrend with the possibility of a huge surprise.

Many are calling for a top or touting that valuations are stretched, but we tend to look at the weight of the evidence which tells us that market conditions are improving and not deteriorating. From a technical perspective, the recent action in the small capitalization stocks and transportation stocks offers some clues.

The chart below is a daily chart of the Russell 2000 small cap index. These small cap stocks have been lagging the general market for about 10 months (shaded green area) and just recently broke into a new high after doing nothing for 10 months. With an important index just breaking out to new highs, how can one say we have run too far or too fast!? The indication here is that most probable course of action for stocks is to go higher, a lot higher.

Similar action can be seen in the Micro Cap Index IWC, the point being that this is a very bullish scenario, stocks do not breakout out of a long consolidation in bear markets, or near tops; this is more of a beginning of a move.

We can get further confirmation of this trend by looking at the Dow Jones Transportation Index which also broke free from a 10-month range (shaded green area). This confirms what is referred to as the Dow Theory, which states that a major trend in Dow Jones Industrials needs to be confirmed by a similar move in the Dow Jones Transportation Stocks. Thus, we have the Dow Jones Industrials (not shown) and the Dow Jones Transportation Index hitting new all-time highs a very bullish signal.

These recent stock price highs are supported by recent economic numbers: The Conference Board Leading Economic Index (LEI) for the US increased 0.4 percent in August, following a 0.3 percent increase in July, and a 0.6 percent increase in June. According to the board, the August gain is consistent with continuing growth in the U.S. economy for the second half of the year, “which may even see a moderate pick–up” according to Ataman Ozyyildirim, Director of Business Cycles and Growth Research.  Further comments from the Director included: “While the economic impact of recent hurricanes is not fully reflected in the leading indicators yet, the underlying trends suggest that the current solid pace of growth should continue in the near term.”   We also know that a recession never started with a positive growth in the LEI.

The final GDP report for the second quarter showed growth of 3.1% versus estimates for 3.0%.  Growth in Q3 looks likely to continue although we may see some impact from recent hurricanes.

So, with all this known what can possibly surprise us in the fourth quarter?

Now, this is not a political piece as we are agnostic to who is in the white house, but we do look at policies. I am talking about policies that incentivize individuals and entrepreneurs to create things, which translate into productivity, jobs and a robust economy.

At this time, it would be safe to say that most everyone does not expect President Trump to get anything done. The market at the same time is pricing in – no tax cuts or reform.  In fact, it would be safe to say that the media has convinced the country that the President is unfit and he can’t get anything done.

Let’s take a step back – pundits and the media said Donald Trump could not run for president, could not get the Republican nomination, could not win the Presidency, and when he did, they predicted a stock market crash. So far not a very good track record, they have been wrong on every point. I am just laying out the case for keeping an open mind.  So just think what if we get tax reform, tax cuts, infrastructure bill or repatriation of trillions of dollars? That will be a big surprise which can get the economy moving or as John F Kennedy said “to try to get this country moving forward again” (sound familiar).

Also from JFK: “The final and best means of strengthening demand among consumers and business is to reduce the burden on private income and deterrents to private initiative which are imposed by our present tax system,” an across the board top to bottom cut in personal and corporate income taxes to be enacted and become effective in 1963.  JFK went further on to say, “to increase demand and lift the economy the Federal Government’s most useful role is not to rush into a program of excessive increases in public expenditures, but to expand the incentives and opportunities for private expenditures.”

So, you can see the current policies are just taking what was already done and historically proven to work based on John F Kennedy history and again through the Reagan recovery. If you are wondering how I can take such a leap of faith that the current administration will accomplish this, I am an optimist and based on the progress in reducing regulations already occurring this year, we can afford to be optimistic.

In past letters we highlighted the surge in recent business and consumer confidence surveys. Furthermore, the economy revved up to a 3.1% growth rate in the second quarter and some estimates for third quarter GDP are even brisker at around 3.4 % with some top economists calling for 3.8% ( this may change as mentioned due to the hurricanes) and the Dow is up about 3000 points since the election.

It is important to pass these pro-growth policies since history has proven that progressive or socialist policies erode wealth and promote poverty. History has shown that no growth in wages occurred during those periods when economic policies moved in the direction of the progressive agenda.  Since 2008, the US has slipped 9 times in the Heritage Foundation’s Economic Freedom Index to  number 17, the lowest ever.  Quickly moving from a ” free” category to a “mostly free” category. The US is the only country to have recorded such a sustained loss of economic freedom in recent years and the causes of the decline are clear. Substantial expansion in the size and scope of government under the Obama Administration, including new and costly regulations in areas like finance, health care and the environment. This has hit every American in some way and reducing opportunities for non-governmental production and investment.

This is important for countries with stronger economic freedom scores to outperform others in economic growth, long term prosperity and social progress. Those losing freedom, risk economic stagnation, high unemployment, and deteriorating social conditions.

The current administration has been working on reducing regulations and taxes. Trump has ended Washington’s war on business. The White House reports that instead of two regulatory rollbacks for every new regulation enacted, as Trump promised, there have so far been 16 rollbacks for every new rule. For example, deregulation has caused a renewed surge in American energy production — including a big lift for coal. Rather than putting coal out of business as Obama and Hillary promised to do, under Trump, America is now exporting American coal to places in East Europe, such as Croatia.

Love or hate the New President, but the fact is something happened that shifted the economy into higher gear, and with the passage of more pro-growth policies, this boom may only be getting started.

Get ready for a huge surprise!

Lastly, I will leave you with an image of the Wall of Worry that stocks always climb (courtesy of Marketsmith).

Or, if you want, you can use the form below to fill in any other concerns you may have.

 

RCM Managed Asset Portfolio

By Christopher Chiu, CFA

 

Current Market Environment

During the past quarter, markets continued to make incremental highs. Even with the risk of a conflict with North Korea and a spate of natural disasters in North America, volatility in the U.S equity markets remains historically low. This may be an indication that the equity market’s true focus at the present time is economic and corporate earnings growth and that participants still remain hopeful for an Implementation of pro-growth economic policies.

(1) Tax policy. Aside from deregulation, the most important pro-growth policy is the new administration’s anticipated tax policy. As we have said for two quarters, the current statutory US corporate tax rate stands at 35%. If the Republican-controlled Congress can pass legislation that lowers the tax rate by even 5%, these companies would immediately realize gains in corporate profit. For example, if the US corporate tax rate went from 35% to 30%, that would be an almost 15% boost to domestic earnings.

(2) Global and domestic growth. On the global front, growth has returned to Europe and parts of the emerging world. In Europe, this seems to be brought about partially by a more certain political environment with this summer’s elections in France and Germany. The boosted confidence in turn has led to continuance of business confidence and low interest rates in the EU.

Domestically, while unemployment rates are at their lowest levels in years, their inability to decline significantly from here show the amount of slack that still exists not only in the labor market but the US economy overall.

 

Bonds

Gov’t, High Credit Corporates

While rates have risen from levels at this time last year, there has been a pause as the Fed continues to assess the current economic environment. Foremost, on the minds of its members is why inflation remains persistently low despite low unemployment levels.  There is now the expectation that the Fed may raise only once more this year. Bond prices consequently have remained at high levels over the last few months.

Elsewhere, the ECB has signaled its intent to wind down asset purchases, taking a similar stance as the Fed when it comes to tightening. As we have often said the central banks often move in concert and the path for rates worldwide is to move higher going forward as the world economies continue to recover from the last recession.

With this being said, when this current credit cycle comes to an end, we expect bond prices to be volatile.

High Yield

High yield continued to experience a rebound from last year’s lows. This has been partly due to the influx of capital into the market as investors still look for yield in a rising but low rate environment.

With defaults currently well below 4% and with a new administration advocating pro-growth policies, it seems that the credit cycle may be extended for an undetermined period. Investments in the high yield market represent riskier investments among the risk spectrum. We expect this sector to be among the most vulnerable to any increased risk and volatility; but, it will also be among the fastest to recover in any recovery of credit markets.

 

Equity Allocation

Recent developments in Large Caps and Strategic Knight

Equity markets had a moderate gain for the third quarter, spurred by the hope of pro-growth policies. As stated previously, over the long term, we anticipate that lower oil prices will have a positive effect on stocks.

As many financials have benefited from increased rates and the widening between short and long-term rates, all of which we expect to occur over the next year, you should expect us to remain weighted more heavily toward financials for the remainder of the year.

In the Strategic Knight portfolios, we remain heavily invested in the tech sector. We think companies such as Amazon and Facebook have an overwhelming competitive advantage in their respective spaces. As witnessed by Amazon’s purchase of Whole Foods, it is through size and inventory turnover that Amazon expects to get smarter about consumer behavior. These learnings are then reapplied to servicing their existing and future customers. We do not see these size advantages, which have been enabled by the Internet, changing in the foreseeable future. In fact, we only see them continuing.

Small and Mid-Caps

Lately small caps have performed quite well as the dollar has rebounded from weakness earlier in the quarter. In the Strategic Knight portfolio, we have increased our allotment of small and mid-size caps. We particularly like some of the smaller cap companies we own as they have found niches we believe are defensible over a long period of time. For example, with Vail Resorts, we believe we own an asset that will have enduring competitive advantage well into the future. After all, there are only a limited number of places where a ski resort can exist and getting the permission to build a new one isn’t all that easy. Further the company has an interesting customer acquisition strategy. Some years ago, it instituted a yearly universal ski lift ticket, where the purchase of the lift ticket in one location could be used at other locations within the company. Then, the company purchased ski locations near metropolitan areas. Their plan, it seems, is to increase the traffic to some of their larger locations in Utah, Colorado, and California by making them more attractive and available to urban customers through this universal lift ticket.

As for other mid-sized companies in the portfolio, we also think the business model of homebuilder NVR, Inc. has some advantages that are not shared by its competitors. First, it does not purchase the land on which it builds properties, rather it purchases an option. Consequently, it does not borrow heavily and incur the risk other homebuilders may face if the properties are not sold. Second, it builds and sells most of its properties in the Washington DC area, where seven of the ten wealthiest counties are located. Though somewhat urbanized, there is still much development in and around the DC area.

In the mutual fund portfolio, we continue to maintain an equal weight exposure to small and mid-caps. Unlike large caps, which have a large portion of their sales to international markets, small and mid-caps sell almost exclusively to domestic markets. We view that in the long term, as rates begin to rise, there is ample cause for the dollar to strengthen. Drawbacks to investments in the small and mids include the higher levels of debt to capital when compared to historical norms. This implies higher levels of risk that need to be weaned down over time.

Our Strategic Knight Position in UnitedHealth Group

Recently one of our biggest holdings as there was discussion of repeal and replacement of Obamacare with the Graham-Cassidy bill. That bill would have likely lessened healthcare payments to the health sector overall as the distribution of federal payments to insurers would occur under a block grant system to states. As a result, UNH declined significantly as the bill was being heard, under fears that payments to the insurers would become less profitable than under the current system. As it was, the bill did not come to a vote as it was a few votes short of passage.

Regardless, we think that the decline will prove to inconsequential. UNH was one of the earliest national insurers to leave the Obamacare exchanges, as they judged–after having been a year within the exchange–that it would not be profitable to remain. Further, a large part of UNH’s growth comes from its Optum analytics business, which we believe will provide it with customer lead flow for years to come.


The general information provided in this publication is not intended to be nor should it be treated as tax, legal, investment, accounting, or other professional advice. Before making any decision or taking any action, you should consult a qualified professional advisor who has been provided with all pertinent facts relevant to your particular situation.