RCM Managed Asset Portfolio
By Christopher Chiu, CFA
Current Market Environment
During the past quarter, equity markets continued to experience volatility albeit less than earlier in the year.
On the positive front, catalysts to the market now include:
(1) Domestic growth. The economy continues to grow at higher levels than in the recent past. Domestically, while unemployment rates are at their lowest levels in years, wage growth remains limited. However, with economic growth continuing, we are likely to see some wage pressures on certain types of jobs in the future.
(2) Credit cycle. While we are in the mature stages of the business cycle, the end of the credit cycle has only now begun with LIBOR rising, but not yet topping out. Further, we have yet to see an inversion of the yield curve which has generally been a signal of an eventual recession.
A number of potentially negative catalysts appeared to be in the forefront during the last quarter, including:
- Rising rates. While there has been some divergence in central bank policies, there is a growing consensus among the major central banks that tightening is warranted. In the U.S., Chairman Powell has outlined the path of rates over the next two years. So, while we have yet to see an inversion of the yield curve, the yield curve has generally been flattening for the last 18 months.
- Over the last quarter, the administration announced further tariffs on China and North American and European allies. These in and of themselves may not have large impacts on global GDP, but the fear of additional tariffs may have large effects on markets going forward.
- Global growth. On the global front, growth in Western Europe has slowed and parts of the emerging world now contend with weaker currencies versus the strengthening dollar. Meanwhile, the risk of war with North Korea stemming from heated rhetoric appears to have abated.
Gov’t, High Credit Corporates
The Fed continues to raise the Fed funds rate as inflation is currently at or above its target. It has signaled that it will continue to raise incrementally for at least the next two years. Bond prices, especially longer dated issues, consequently have shown price declines. We expect this to continue as the Fed attempts to normalize rates. It remains to be seen what the high point for various rates will be in this credit cycle, but it seems it will be somewhat higher from where we are today. As a result, we had significantly reduced our exposure to longer dated corporate holdings in the mutual fund program and increased our allocation to floating rate.
Among corporate bonds, high yield performed well for Q2. Credit conditions still remain fair, but there is a limited upside to high yield.
With defaults currently well below 4% and with a new administration advocating pro-growth policies, it seems that the credit cycle may continue for an extended period. Investments in the high yield market represent riskier investments along 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. We anticipate making a return to this allocation after prices have declined significantly at the end of this credit cycle.
Recent developments in Large Caps and The Strategic Knight
Equity markets began the year on an upswing, spurred by the implementation of pro-growth policies. However, during the last week of June equity markets had been volatile.
In the Strategic Knight portfolios, we remain heavily invested in the large cap tech sector. We think companies such as Amazon have an overwhelming competitive advantage in their respective spaces. We do not see these size advantages, which have been enabled by the Internet, changing in the foreseeable future. The one risk that has become greater is future regulatory risk. While the legislative process is a slow moving one, various thought leaders continue to express concerns about the size and influence of large cap tech on competitive markets. Without new competition, it’s hard to see how this negative press diminishes in the future.
This quarter we also opened positions in Netflix.
Small and Mid-Caps
Lately small caps have performed quite well as the dollar has rebounded from some weakness earlier in the year and as small and mids are expected to benefit from tax reform. In the Strategic Knight portfolio, we had increased our allotment of small and mid-size caps.
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.
You Don’t Just Need Product, You Also Need Distribution!
Businesses are made by two things, product and distribution. While having a wonderful product is necessary to have a wonderful business, without having a good distribution system the business will struggle. By distribution I mean a way for the business to find new customers. Without distribution no one will ever learn about the usefulness of the wonderful product.
Focusing on distribution used to make investing easier.
For a long time in investing–I would say from the 1970s onward– you could find many examples of great businesses to invest in, that is, businesses with a good product and a distribution that grew over time. The way you could track the growth of that distribution was by counting the growth of physical locations over time.
A good example of this was Wal-Mart. If the Walmart store was successful in central Arkansas with its discount shop, it could spread this store concept to different part of the South and Midwest and then to the rest of the country under the assumptions that Americans have similar tastes wherever they live. You can find example after example of this from the last fifty years in investing, not only in discount stores thru Walmart, but also groceries thru Whole Foods, fast food thru McDonalds, discount airlines thru Southwest and the growth of their new gates and routes– Buffalo Wild Wings, Ulta Salons, Coach, the Gap, Starbucks. I could go on and on.
This was for a long time; the predominant way retailers grew their business. This made sense if you think about how the growth of the American consumer economy paralleled that of the growth of automobile culture. As Americans moved away from urban centers and toward the sprawl of suburbia, and as new communities took form, there had to be a system for the post war generation to learn about and buy new types of goods. The learning took the predominant form of TV and radio advertising as well as seeing what your friends and neighbors had bought and how they were living. And the purchase took place in physical locations, the stores in the mall that the company had decided to place for that community.
You could make investments in these growing companies because often times the companies would disclose how they were going to build out their distribution system in the form of physical locations. They aimed to get to a certain number of locations within x number of years. So, if you believed in the management and their ability to make projections through their capital budgeting and their ability to execute that plan, it was therefore easy to apply a growth rate over a number of years and put it into a valuation model to get a value. The investment decision used to be a lot clearer.
The Internet has Disrupted the Past Distribution Model.
Much of this investment clarity about the value of a retail business has since gone away with the internet. Retailers are now focusing on direct to consumer thru the internet, or they are focusing on multichannel, which is another way of saying they selling through the internet as well through other distribution points like department stores and catalog.
There are still exceptions to this massive change of distribution. Some services can only be provided by having a physical location. A good example of this is Ulta Salons where you can only get the service by going to the location (no one can deliver you a haircut!). But the changing way of making sales from the old system of distribution is undeniable. More commonly the store now acts as a showroom in addition to being a point of sale, as when the Apple store is used for potential customers to try new gadgets rather than only a place for gadgets to be sold.
So, what is the new distribution model?
As I said earlier, the exclusivity of physical locations as the main form of sales distribution has been replaced by the Internet. And yet, products are still being sold. And companies are still growing. Therefore, it must mean there is some other form of growing distribution. What is then, the new distribution model?
Over the last couple of years, the FAANG companies have become notorious for creating value by nontraditional business metrics, namely user growth which has led to price momentum. Criticism especially has been placed on Amazon and Netflix, since, it would be said, the companies don’t generate enough cash to justify their current valuation. Perhaps investors shouldn’t be using user growth as a metric to valuing companies especially, but investors nevertheless should understand why user growth is an important metric in possibly generating cash in the future.
In the Internet era of business, companies still aim to reach new customers. And they want to be able to allow customers to discover new products. The difference now is that the build out is no longer in a new location, but something more specific that would only exist because of the internet. I would suggest the new distribution point is the customer itself and the amount of new services that can be sold to them.
This only became clear to me when I heard about Spotify’s business model. Spotify current business model is a streaming service to its subscribers, a subscriber base that has only grown as subscribers experience the value of Spotify’s algorithmic playlists and learn to trust the company. But as Derek Thompson, a senior editor of the Atlantic, has suggested the next logical step for Spotify is to offer a much more profitable video service on top of the music services currently being offered. In this way Spotify increases sales by providing a new service, but it will have done so not by creating a new physical location; it will have done so by using the customer as the distribution point for the sale of that new service.
This is just to give one example. But you can find this same pattern of selling additional goods and services to the customers of Amazon, Apple, and Netflix. And if you believe distribution has any importance at all in the success of a business, then in age when the distribution model is increasingly changing from one of physical location to that of customers themselves, you will understand why the number of users is such an important metric in this age of Internet companies and why FAANG stocks have done so well over the past few years.
By George Tkaczuk, MD, MPH
There is a saying in the stock market that “the market and the economy are not the same thing.” This might be true on a day to day, week to week, or a monthly basis, but over time indicators showed that these two can move together. The reason I bring this up is that the economy is expanding but the market continues to be range bound. Naturally, this sort of corrective trading range we have been seeing since late January raises concern for investors, at which point they question their sanity for staying invested in the market. This is what the market loves to do, fool the masses. Just when you think it is going to go up forever (think January 2018) it corrects, and just when you think it is going to go down forever (think February 2018) it rebounds and moves higher.
You may remember this chart from last quarter’s newsletter – the S&P 500 is still in the range bound box, but, we are making higher lows and looking for higher highs. This is very constructive.
It is important to note that the overall trend is higher, but more importantly the expansion in the economy is continuing and the stock market will follow the economic expansion, and the market will be higher this year.
The basic story of the stock market is that it begins with the end of a recession and ends with the beginning of the next recession. The market bottomed in 2009 at the end of a recession and continues to rise until we run into the next recession. In the meantime, it keeps people off balance, goes up and down trying to fool everyone – all the time.
So, the question is – how does one deal with this up and down action? How does one know if this is the end of this long uptrend and the beginning of the next recession?
To be able take advantage of this scenario, to understand whether you should be invested in stocks or in cash, you need to understand where we are in the economic cycle. Are we in an expansion? Is it ending? Or did it end? Are we heading back into the next recession?
Let me try to calm your fears and put them to rest by telling you we believe we are in an economic expansion; the overall trend is higher – we have not seen the high just yet. How can I be so positive about this? – Don’t just take my word for it! We look at various data, and that is data that matters. So, I will briefly go over some recent data that really matters.
Civilian unemployment rate is at 3.8%, the lowest level in 49 years. Our economy is made up of about 70% consumption, as consumers are employed they get money to spend to pump into the economy. At the same time, corporations have to invest in factories to produce goods for the consumers and that in itself creates more jobs and wages. Unemployment peaks before any recession and we are not there yet. Some economists predict by the end of 2019 the jobless rate will be 3.2%, which would be the lowest since 1953. It’s now possible that, by 2020, the jobless rate will fall below 3%.
Wage growth is also occurring the last non-farm payroll report showed a 0.3% increase in average hourly earnings, which are now up 2.7% from a year ago and total earnings – which combine the total number of hours worked and average hourly earnings – are up a respectable 4.9% in the past year, an amount which will keep up consumer purchasing power.
Retail sales rocketed 0.8% in May, logging the largest gain in seven months. Retail sales are up a strong 5.9% from a year ago (6.4% excluding auto sales). This report showed accelerating consumer spending and according to some economist supporting a 4.5% real GDP growth in the second quarter.
New home sales rose to their second highest level since 2007. Sales rose 6.7% in May to a 689,000-annualized rate and are now up 14.1% from a year ago, the ninth month in a row of year-over-year gains. New Home sales tend to peak a year or two before recessions. Looks like we still have room to run.
Corporate profits reached a record $1.92 trillion, up almost 17% from a year ago. That is equal to 9.6% of GDP a level that has been exceeded in only 4 quarters in our nation’s history. These will likely even move higher once the full impacts of lower corporate income tax rates take effect.
Truck tonnage is up 7.8% year over year and is up at an annualized rate of 7.8% year to date. “This continues to be one of the best, if not the best, truck freight markets we have ever seen,” said ATA Chief Economist Bob Costello. “May’s increases, both sequentially and year-over-year, not only exhibit a robust freight market, but what is likely to be a very strong GDP reading for the second quarter. However, in the near-term, look for moderating growth rates for freight simply due to more difficult year-over-year comparisons, not from falling tonnage levels.”
Trucking serves as a barometer of the U.S. economy, representing 70.6% of tonnage carried by all modes of domestic freight transportation, including manufactured and retail goods. Trucks hauled nearly 10.5 billion tons of freight in 2016. Motor carriers collected $676.2 billion, or 79.8% of total revenue earned by all transport modes.
The above are just some examples of robust economic data. This is data that matters. Keep in mind as we go forward the market likes to fool you with knee jerk reaction to headline news. The November election looms we may move sideways, however as long as the economic data is solid, the stock market will be fine.
As we enter earnings season for Q2 2018, the estimated earnings growth rate for the S&P 500 is 20.0%. If 20.0% is the actual growth rate for the quarter, it will mark the second highest earnings growth since Q3 2010 (34.0%). This is not the kind of data you typically see in recessions.
Lastly it is worth mentioning rising interest rates. While the Fed is raising interest rates they still are not “tight,” but in fact still very accommodative. Furthermore, the Fed is raising interest rates because it sees a growing and improving economy. Contrary to popular narratives, stock markets do well in rate rising environments, because rates go up in strong economies! We will not see the stock market peak until after a peak in rising rates, and we are a far way away from that.
Putting it all together: we have job growth, wage growth, retail sales, deregulation and tax cuts, a very healthy consumer, raising rates, and an accommodative Fed, thus the outlook looks very bright!
Lastly, I included a 100-year, yearly chart of the Dow Jones Industrials, just to give you the 33,000-foot view, – that we are only a few years into our bull phase.