Strong Fundamentals Despite A Dwindling Safety Net
Although volatility remains elevated relative to last year, financial markets have stabilized somewhat after a tempestuous February and March. While markets, and riskier assets in general, remain off the highs seen in January, several risks that stirred volatility have largely abated or were misunderstood. As a result, we believe the positive economic and market backdrop will eventually triumph, which keeps us positive on stocks.
Over the last several years, rising asset prices and low volatility began to feel all too normal. Aside from an occasional dip, equity markets seemed to be a one-way bet. That created more anxiety over the market correction that began in early-February. However, by historic standards, that initial decline of nearly 8% in the S&P 500 does not look all that notable. What was remarkable was that, until February, the S&P had not seen even a 5% decline for more than 400 days, surpassing the previous record set in 1996.
We think that much of the market’s movement was due to rekindled inflation fears and concerns that interest rates might rise more swiftly than expected. Additionally, the winding down of quantitative easing globally (the “safety net”) and certain portfolio strategy repositioning created wild movements in the market that lead to the first correction since early-2016.
With that in mind, we’d point out that market “tops” take time to form and, in our opinion, greed is harder to shake-off than fear. Earnings growth remains a key catalyst for equities over bonds and credit. Additionally, rates, the US dollar and wage growth are not yet high enough for an inflection point in corporate profitability, which could be a headwind for risk assets.
We maintain our positive outlook for most equity markets and do not expect bond yields to continue to rise at their recent pace. In fact, yields on government bonds have even leveled out in recent days. Overall, we remain constructive for equities, due to the synchronized global recovery, which we expect to underpin strong earnings growth. Given that until recently, investor sentiment was near record highs, we think that some sort of correction was indeed overdue. For stock pickers, such phases can certainly bring opportunities. And below we lay-out five top ideas as the market digests the “noise.”
A Few Favorites
- Amazon (AMZN): The company has been allowing profit margins to drift higher while still investing in the business which has resulted in further “wallet share gains” as it leads the offline/online retail convergence. Additionally, Amazon has expanded its lead in cloud with AWS and invested in categories such as voice and advertising, which has made it one of (if not the most) forward looking companies out there.
- Bank of America (BAC): Bank of America is one of the world’s largest financial institutions, with ~$2.3 trillion in assets. The company should be a direct beneficiary of continued synchronized global growth, rising interest rates and from a “troika” of confluences from tax reform: accelerating earnings growth from a lower tax rate, improved profitability that can be redeployed for a higher dividend payout and rising deposit growth from taxpayers’ savings which are then loaned out at higher rates.
- Facebook (FB): The company’s reach, targeting and ad-unit quality make it one of the most unique and dominating ad platforms in the world. Yes, there is “noise” and Facebook’s user growth is slowing, but we believe continued improvements to ad targeting and ad units are driving improved ROI for advertisers, which will ultimately lift demand. In addition, the company has incremental growth prospects from Instagram, where monetization likely remains well below the core Facebook platform despite a highly engaging and visual experience, Watch, which increases the potential to capture TV ad dollars, and messaging.
- com (CRM): Salesforce has an impressive track record of execution achieving the $10B revenue run-rate milestone this year with high ambitions to double revenue to $20B as it expands its leading market position in sales force automation tools into a more broadly adopted digital cloud platform that also spans service/support, marketing, commerce and application development. Successful cross-selling and continued share gains could sustain 20% or higher revenue growth, with operating margins (an indication of profitability) can expand 1.0 to 1.5 percentage points a year.
- Visa (V): Visa is a key beneficiary from secular growth across the globe that is leading to strong double-digit underlying revenue growth and 15-20% EPS growth over time. We believe the company is in a situation with several possible catalysts and tailwinds this year, such as tax reform, continued solid spending trends, foreign exchange benefits and further Visa Europe synergies. Additionally, it’s a good play on rising rates, inflation and gas prices.
On March 1, President Trump claimed he would impose stiff steel and aluminum tariffs on imports. This news rattled the market. Trump abruptly proposed tariffs of 25% on steel and 10% on aluminum. He said the tariffs would be put in place the following week. These comments came after a Commerce Department investigation last month determined that imported metal was degrading the US industrial base. US metal manufacturers surged that day, but the rest of the market fell on the prospect of an escalating trade war. There are many facets to this topic that are worth diving into.
Market reaction: Fueled by unfounded inflation fears
The market is heavily driven by the Fed and its interest rate changes. The Fed is largely driven by inflation figures. When investors heard that tariffs might come into effect, it stoked inflationary fears. However, steel and aluminum tariffs would hit only about $40bn to $50bn worth of imports, out of total imports of $2.9 trillion last year – that’s just 1.6%. Commerce Secretary Wilbur Ross also came out with a statement on March 2nd that inflation from the tariffs would be minimal.
Political angle: Fighting for a NAFTA deal
Since then, there has been a lot of discussion on real motives and the likelihood that these tariffs will actually come to pass. While much of the rhetoric has been aimed at China and Russia, a lot of the subtext about this story revolves around the current NAFTA negotiations. As you can see from the graphic below, two of the top 3 steel exporters to the US are our current NAFTA partners: Canada and Mexico. Indeed, on March 6, Treasury Secretary Steven Mnuchin said Mexico and Canada could escape the tariffs if NAFTA gets done.
Source: New York Times
Politics: Tariffs are not great for political parties involved and do not have desired result
Historically, when elections were at stake, tariffs did not work well for the incumbents:
In 2002, George W Bush imposed steel tariffs with a similar thesis. The tariffs exacerbated several issues that they were trying to fix. The US ITC later found that they did not have a positive effect on the industry’s job count. In 2003, the tariffs were repealed after a WTO ruled that the tariffs were illegal.
Since the announcement, Trump has lost some of the support of his party. A cohesive party will be critical as the Republicans are working hard in primaries for upcoming 2018 mid-term elections.
So what now?
Over the last few days the White House has backtracked from some of its statements, offering potential for compromise. Additionally, big investors, like hedge fund billionaire Ray Dalio, have dismissed the rhetoric as just that: rhetoric. With tariffs looking less like a global trade war and more like NAFTA posturing, the market rallied on March 5.
Departure of Cohn
On March 6, Gary Cohn, Trump’s chief economic advisor and former Goldman Sachs COO, announced that he intended to resign. This is the latest in a string of departures from the Trump Administration. Neither Cohn nor the Whitehouse gave specific reasons for the resignation. However, Cohn was seen as a long-time believer in free markets and as a great advocate for Wall Street. Many believe he resigned specifically because of the tariff proposal. Markets opened lower on March 7.
We think the market will ultimately look beyond the rhetoric and jockeying in the near term. We will still see volatility around this topic until it officially plays out, but we remain positive on the market because:
- Earnings growth remains solid and have an upward bias due to tax reform
- A healthy, and accelerating, global macro backdrop
- Positive consumer sentiment
- Rates that are still low relative to historical norms
- A weak dollar
As always, if you have any questions, we are here for you!
Stores are not going away – it’s how we use them that is changing. Catamount is a firm believer that the future is digital. We think names like Amazon, which enables a digital marketplace, and Visa, which enables digital payments, will be big winners in the future.
We have previously written about cord cutting and talked about Amazon’s move to create a digital store for almost anything. In this environment, many on Wall Street and in Silicon Valley now believe Macys’ and JCPenny’s days are numbered. The beginning of this century has been the story of the internet and the move from the physical to the digital world. Then, why have so many online retailers started opening physical storefronts?
Digital retailers open physical storefronts
Famously, Amazon bought Whole Foods in 2017. Many of those Whole Foods locations now have Amazon lockers in them where customers can come to physically pick up items they ordered online. This week, after significant hype, a fully automated Amazon convenience store “Amazon Go” has launched.
Bonobos, a menswear retailer founded in 2007, radically redefined its online-only strategy when it opened about 50 physical stores from 2012 through 2017. This strategy worked so well that Walmart bought the company for $310mm in June 2017. You now see Everlane, another clothing company known for being online only, opening its first store in NYC this year.
Warby Parker, an eyewear maker founded in 2010, became famous as an acclaimed success story when many initially thought no one would want to buy prescription eyeglasses online. Almost overnight, 65 physical Warby Parker stores now exist with many of them offering in-store eye exams. Warby Parker’s most recent investment round valued it at $1.2bn.
Casper, founded in 2013, started out as an online-only mattress company. The company would ship you a mattress, allow you to use it for 40 days, then return it if you were not satisfied. In late 2017, Casper announced that it would open at least 18 storefronts between the end of 2017 and beginning of 2018. Around the same time, Casper received a major $170mm investment led by big box retailer Target.
Many, many other smaller online companies have moved from the only digital to the physical world by opening up storefronts in major US cities, including: M.Gemi, Allbirds, Away, ModCloth, Glossier, and Madison Reed.
And big brand retailers push dollars into online stores
Many retailers that were previously purely physical have seen the competition coming. Walmart, Target, Costco, BestBuy, and others have invested heavily in building out their own online store capabilities, as well as acquiring and investing in smaller companies to build out brand and prowess.
Walmart has shined brightly here. Through online channels like walmart.com and samsclub.com the company has a significant online presence. In 2016, Walmart also bought Jet.com, billed as a direct Amazon competitor. In Q3 of 2017, Walmart announced that online sales were up a whopping 50% from the year prior. While this figure is partially inflated due to the Jet.com acquisition, it is impressive nonetheless. Walmart launched ecommerce operations in both Canada and Mexico. The retail behemoth also announced that it was going to double its online grocery store pickup location number by adding more than 1,100 new pickup locations. As mentioned earlier, the company also bought Bonobos in 2017.
Target is another company focused on its digital transformation. It recently opened several smaller format stores and plans to open 75 more by the end of 2019. Target also committed to remodel 600 stores to better display product and integrate with an online experience. Target’s digital sales figures grew 24% over last year’s figures. As mentioned earlier, Target also invested in Casper. In December 2017, Target bought Shipt for $550mm. Shipt is Target’s second acquisition focused on enabling better same day deliveries and shows the company’s push to compete with Amazon in the digital space.
So, who wins?
Online companies that approached the challenge later will have an advantage of being agile and not having to worry about upkeep costs at existing stores. The incumbent competitors here are being forced to invest heavily in online retail and revamping those existing stores. The new, nimble entrants will have a better view of what physical stores and associated costs make sense vs a bigger online spend. You can see the success of the newcomers’ strategy in the investment by Walmart and Target in young startups. Target’s move to reform its old spaces to fit a more online-focused sales strategy shows that this is where the industry is headed. Will all the old school brick and mortar retailers fail? Probably not. Will the more nimble and well-funded startups succeed? Not necessarily.
The store of the future has both an online and a physical presence. We at Catamount think that online retailers that have more mobility, like Amazon, will have an advantage going forward as they are setting the pace and not playing catch-up. We also think that companies focused on digital payments, like Visa, will be set up to succeed in a world where people are using more credit cards and less cash.
A Run Down on Tax Reform
It’s official! The massive revision to the US’s tax code is nearing completion. All that’s left is for President Trump to sign the final version, which is expected to happen in the next week or two. Although Congress “bills” this (pun intended!) as a great accomplishment, it still leaves individuals and companies scrambling to figure out what it means and how we’ll be impacted as there are numerous changes to the tax code. Although not economists or tax/accounting professionals, we take a stab at the key points that affect individuals and corporations, and provide a comprehensive list of updates in the appendix for your perusal.
The nearly 1,100-page bill (if you’re having trouble sleeping, check it out here) was filed late Friday, December 15th and passed in the Senate (51 to 48) and House (227 to 203) the ensuing Wednesday, almost along pure partisan lines. For what it’s worth – as far as our due diligence is concerned – this is the first tax bill ever passed along party-line votes and goes beyond just taxes by repealing the Affordable Care Act individual mandate, moving to a “chained” inflation estimate for tax bracket threshold adjustment, drilling in the Alaskan Arctic National Wildlife Refuge, among others. Additionally, it’s worth noting that these “reforms” increase our government’s balance sheet by almost 2X the stimulus from the Obama administration that took place at the top of the financial crisis.
From a high-level, the bill is a bit like when Buddy eats spaghetti for breakfast in the movie “Elf”: looks messy but I like a lot of those ingredients. Although the bill has a “fiscal cliff” – meaning a big percentage of these changes expire – for individuals in seven years, it is arguably the most substantial corporate tax overhaul in over 30 years. Overall, it has tax rate cuts for a good portion of individuals and families, but it significantly reduces the number of deductions available for a significant portion of taxpayers. Additionally, it cuts tax burdens for corporations and alters how the government taxes international companies (including bringing back cash held overseas).
The main question is how does this affect you? The quick answer is: it’s complicated and varies case-by-case. But according to the Joint Committee on Taxation in Congress, middle income households (annual income of $20K-$100K) should save $61B through these measures as soon as 2019. However, those cuts are set to expire by 2027, which will then generate a net tax increase for those households. Conversely, according to the JCT, the wealthiest (over $500K a year) will see the same savings in 2019 but an additional $12B in savings by 2027.
From a company and portfolio perspective, it will clearly have a positive impact to Catamount’s favorite theme: earnings! According to Bank of America which surveyed over 300 domestic companies, 65% said they would use the “savings” to pay down debt, which should lower interest payments and raise earnings per share – further enhancing the EPS growth we’ve been accustomed to since the Great Recession. Of note, corporate debt issuance in the US has risen every year except one since the financial crisis, and it is on pace for a record year in 2017, so a deleveraging of the corporate balance sheet as a whole is positive long-term for the economy. Additionally, when the Bush Administration implemented a “repatriation holiday” in 2004, which allowed for companies to cheaply bring back cash abroad, approximately 80% was used for buying back their shares. “Buybacks” theoretically result in shares rising and show confidence to investors.
We at Catamount believe lower tax bills will result in a combination of the two (debt paydown and share repurchases) and could also be a boon for dividends and M&A. All of which benefit shareholders and the stock market, keeping us tepidly bullish on our outlook for equities.
Happy and safe holidays!
– Catamount Wealth Management
DISCLAIMER: Catamount Wealth Management does not provide tax, legal or accounting advice. This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, tax, legal or accounting advice. You should consult your own tax, legal and accounting advisors before engaging in any transaction.
More detail on some of the key items of the bill:
Rate Cuts, Deductions, Credits, Exemptions
- 21% Corporate Tax Rate Starting on January 1, 2018 (“permanent”)
- That’s a 14 percentage point corporate tax cut, which starts right away in 2018
- Top Individual Rate Drops from 39.6% to 37%
- Income thresholds increase from about $418K to $500K for individuals
- From about $470K to $600K for married couples
- This expires after seven years on January 1, 2025
- Income thresholds increase from about $418K to $500K for individuals
- Corporate Alternative Minimum Tax (AMT) Is Eliminated
- We view this as positive news for companies who applied the research & development tax credit, like technology companies
- Individual AMT Was Retained
- However, the exemption was increased from $54,300 ($84,500 for a married couple) to $70,300 ($109,400 for a married couple)
- State & Local Taxes (SaLT) and Property Tax
- You can now deduct $10K for property taxes or SaLT (you can’t deduct $10K for each)
- This goes back to normal in 2025
- Corporate SaLT
- There was no change here, which means corporations can keep deducting state and local taxes
- SaLT in the wound for individuals (bad joke)
- Individual Deductions & Exemptions
- The standard deduction is up nearly 2-fold from $6,500 ($13,000 for couples) to $12,000 ($24,000 for couples)
- Therefore, more will qualify and can no longer itemize
- We see this as a disincentive to own a home
- Personal exemptions are eliminated
- It was $4,150 per taxpayer and dependent
- The Pease Limitation on itemized deductions is eliminated
- As mentioned above, you could deduct property tax, state income tax and sales taxes but now it’s all capped at $10K
- This should go back to normal 2025
- Child Tax Credit (CTC)
- CTC has been increased from $1,000 to $2,000 with a $500 credit for dependents
- Up to $1,400 is refundable
- This begins to phase-out at $200K ($400K for couples)
- CTC has been increased from $1,000 to $2,000 with a $500 credit for dependents
- Mortgage Interest & Home Equity Loans (HEL)
- EXISTING principal home mortgages are grandfathered (continue at current cap of up to $1M)
- This is the same with “second home” mortgages
- However, all NEW mortgages (effective date TBD) can deduct $750K
- Existing HEL are NOT grandfathered and new HEL will no longer be deductible
- EXISTING principal home mortgages are grandfathered (continue at current cap of up to $1M)
- Estate Tax
- The current rate is 40% on estates over $5.6M
- This will now go to 40% on estates over $11.2M
- 529 for K-12
- The 529 plans can now be used for K-12 combined with the traditional college tuitions
- This will apply to $10K per year per child
- This could offset some of the SaLT impact
- “Pass Throughs” (S Corps, LLC, etc)
- Pass through businesses get a deduction of 20%
- Coupled with the lower top individual rate, this equates to an effective rate of 29.6%
- However, most service businesses are eliminated (specifically, health, law, accounting, consulting, financial services, investment management, brokerage services, lobbyists, etc)
- Pass throughs will continue to be able to deduct SaLT
- The 20% deduction begins to phase out at $315K of income for couples
- Medical Expenses
- The deduction for medical expenses goes from 7.5% of your adjusted gross income (AGI) in 2017 and 2018 and then 10% thereafter
- This goes from a 50% AGI limitation to 60%
- Tax preparation, moving expenses, investment advisor fees and alimony are all repealed
Territoriality & Deemed Repatriation
- In 2018, the US will follow suit of most other countries by moving to a “territorial” system
- This is likely a positive for multinationals
- Deemed Repatriation
- 5% on the cash and 8% on the permanently re-invested earnings going back to 1986
- It’s currently at 35% and 15.5%, respectively
- Companies have eight years to pay the tax
- 5% on the cash and 8% on the permanently re-invested earnings going back to 1986
Net-Interest & NOLs
- For the first four years, companies can deduct net-interest up to 30% of EBITDA
- This level turns into 30% of EBIT (no depreciation & amortization added back) in 2022
- The global leverage ratio was not included
- For the first four years, companies can deduct net-interest up to 30% of EBITDA
- Net Operating Loss (NOL) was limited to 80% of taxable income
- The carry back provision was repealed (exceptions for farmers and some insurers)
- 100% Expensing
- Bonus depreciation will be increased from 50% to 100% for qualified property placed in service after September 27, 2017 for a little over five years to the end of 2022
- A phase-down then begins in 2023 in 20 percentage point declines (2023: 80%, 2024: 60%, etc)
- Carried Interest
- This moves from a one-year carry to a three-year carry
- Entitlement Reform (Chained CPI)
- Indexing of income tax brackets and thresholds is permanently changed
- Previously it was linked to the Consumer Price Index for urban consumers (CPI-U)
- Section 199 Repeal
- The domestic production deduction (Section 199) is permanently repealed starting January 1, 2018
- Base Erosion Anti-abuse Tax (BEAT)
- This applies to companies that significantly reduce their US tax liability by making cross-border payments to affiliates
- The 10% tax is increased to 12.5% for 2026
- This is viewed as a win for “clean energy” as a higher rate would potentially discourage some companies from using wind and solar tax credits to cut their tax bills (more below)
- “Minimum” IP Tax
- It appears to be 10.5%, which is below the “Irish Threshold” test of 12.5%
- The producer tax credit (PTC) stays in place along with the electric car credit
- IDCs and all conventional energy tax credits are also unchanged
- Utilities received a carve-out from the net-interest language (trade-off is that they do not get the 100% expensing)
- Note: that is only on their regulated businesses – non-regulated businesses are subject to the net-interest haircut provisions
- Puerto Rico
- Puerto Rico did NOT get its requested carve out from the BEAT and other items
- University Endowment Tax
- University endowments will see a 1.4% excise tax
- Private Activity Bonds are not eliminated, though advance refunding bonds lose their interest exclusion on any bond issues after December 31, 2017
- The bill repeals the authority to issue tax credit bonds and direct pay bonds after December 31, 2017
- First In, First Out (FIFO)
- A controversial provision that would force investors to see their securities on a FIFO basis was not included
- Dividends & Capital Gains
- Nothing in the bill
- The 3.8% investment income surtax remains
- Additionally, the 0.9% Medicare surtax on the wealthy remains
- So the max rate on dividends and capital gains will remain 23.8%
- ACA Individual Mandate
- The tax (or “penalty”) was removed on the ObamaCare Individual Mandate on January 1, 2019
- The CBO predicts this will cause premiums to rise 10% and will cause 13M people to lose coverage over the coming decade
- Pay as you Go (PAYGO)
- PAYGO has been in law for 30 years
- This is a budget rule requiring that new legislation affecting revenues and spending on entitlement programs, does not increase projected budget deficits
- It will now 100% be triggered when the bill passes into law
- However, the overwhelming consensus is that Democrats will agree to waive this trigger by helping the Senate get the required 60 votes
The Future of the Fed
Jerome Powell and the Future of the Fed
Surrounded by many other political and economic stories, a new Federal Reserve Chair might seem unimportant. However, the US Federal Reserve System is one of the most important players in the global economy and a key influencer of the stock market. On November 2, President Trump named Jerome “Jay” Powell as his nominee for Fed Chair and, after what is anticipated to be a shoo-in Senate approval, Powell is set to take the reins of the Fed in February 2018.
So what, if anything, changes with this appointment?
The Fed’s Goals
To understand what might change, it is important to understand the Fed’s role. So first, a bit of boring background on the Fed: The Federal Reserve supervises and regulates the US banking system in general. Its two key areas of focus are maximizing employment and stabilizing prices. It is also seen as a key guard against financial crises. Of the various responsibilities, publications, and mechanisms it uses, the Fed is most widely known as the entity that sets US interest rate targets.
Appointing a Chair
There are seven members of the Board of Governors for the Fed. Each of these is chosen by the President, approved by the Senate, and serves a fourteen-year term. The Chairman of the Fed must be selected from this Board and is also chosen by the President. The Chairman serves a shorter, four-year term. The Chairman of the Fed sets the tone for the Fed and for interest rates. Chairs are usually viewed as “hawkish” if they are in favor of raising interest rates to fight inflation and price bubbles, or “dovish” if they favor lower interest rates to foster lending and increase consumer spending. As an example, Paul Volcker led the Fed when the Federal Funds Rate was raised to 20% in 1981, and is probably the most famous Fed hawk.
Powell’s Appointment: A Drastic Change to More of the Same
The appointment of Jay Powell is notable for many reasons. It marks the first time in decades that a Fed Chair has not been appointed for a second term. While Fed appointments have traditionally been non-partisan, this move is a bit different. Since Ronald Regan, every president who had the option to reappoint a Fed Chair that was nominated by the opposing political party has done so: Regan reappointed Paul Volcker, Clinton reappointed Alan Greenspan, and Obama reappointed Ben Bernanke. The Trump administration considered reappointing Yellen, a democrat appointed by Obama, but decided to change this trend. Powell is a republican and former investment banker who was partner at a famous private equity firm, the Carlyle Group. He is also a lawyer with a law degree from Georgetown, not a PhD economist like the last three fed Chairs.
That said, there may not be that much of a difference in how the Fed acts going forward. Powell is known as a bipartisan dealmaker and has been serving on the Fed since Obama appointed him to the Board in 2012. Indeed, before joining the Fed, Powell was a visiting scholar at the Bipartisan Policy Center in Washington. Powell has generally been supportive of Yellen’s policies. In his testimony to the Senate on November 28, he made it clear that he is a proponent of gradual rate raises, provided that economic activity supports those raises. He also made it clear that he is a strong believer in an independent Fed. Given some of Powell’s statements and his Wall Street background, most observers believe the biggest change between the two Chairs will be a more lenient take on bank regulations going forward.
Implications for Wall Street and Your Portfolio
Wall Street does not anticipate any dramatic departure from Yellen’s gradual raises. According to a recent poll by Reuters, the Street expects the Fed to raise rates three times in 2018. With one more rate hike anticipated in mid-December, consensus anticipates three rate raises each in 2017 and 2018: more of the same.
As these hikes happen, the price of bonds are likely to decrease. In particular, longer-term bonds with lower coupons will be especially susceptible to interest rate changes. Higher rates can also put the brakes on the stock market. As rates rise, investors move money away from stocks and towards new bond issuances. Rising rates also mean that lending tightens which can slow down the economy and decrease corporate earnings.
So, what is our take? Catamount thinks that gradually rising rates, especially when rates are near historic lows, is a prudent use of the Fed’s power. These raising rates should also benefit lenders, like banking stocks, which are a sizeable position in Catamount’s portfolio. As rates rise, banks’ earnings do as well as they are in the business of lending at the prevailing market rates. The Fed is also very vocal about tying interest rate increases to inflation increases. If it does this, corporate earnings should have room for growth and support the fundamentals that are driving the market leaders right now. This type of environment will suit active managers like Catamount better. We are constantly looking at both fundamental and technical metrics to find the right candidates for your portfolio. As always, if you have any questions, give us a call!
Q3 Earnings Season—Don’t Get Spooked
It’s that time of the year again where we can see a snapshot of the health of the economy through the corporate lens. That’s right: It’s earnings season! Over the next several weeks, companies will report their preceding three-month results through SEC filings and, usually, a conference call to discuss results with investors and analysts. These quarterly events are typically paramount for market participants to get a clear idea of business trends that help determine where a stock – and the market – could potentially go.
We anticipate this quarter will deliver strong prospects to warrant further long-term market appreciation but, admittedly, there will be much more “noise” and volatility as headline earnings growth rates won’t look quite as robust as prior periods. Nevertheless, when the onion is peeled back, we think core earnings remain strong and, more importantly, companies’ outlooks for the year-end quarter will add support to the market, keeping us bullish.
Part of the reason for the upward momentum in the equity markets over the last several years has been a result of consistent, rapid earnings growth. For example, in the first quarter of 2009 when the market bottomed during the financial crisis, the forward 12-month earnings per share (EPS) estimate for the S&P 500 was less than $50, compared to today where it’s over $140. That near-tripling in under a decade has been the result of cost cutting and sales growth. Companies have streamlined operations by improving materials sourcing, finding cheaper input costs, innovating and consolidating through mergers & acquisitions. Companies have also used low interest rates to finance expansion into new markets and business segments. This combination has created larger revenue bases and allowed for those revenues to flow more purely to a company’s bottom line.
However, that trend could be disrupted this quarter as two major hurricanes stalled the economy and caused billions of dollars in damage. This disruption will likely be exaggerated by a typical seasonal slowdown that happens during the summer. Waning year-over-year strength from the energy sector could also slow things down. Before the hurricanes, Wall Street expected S&P 500 earnings growth to be 7.5% for the third quarter. In wake of the destruction, analysts revised estimates down to 2.8%. That is a material slowdown from the second quarter where the S&P 500 delivered double-digit earnings growth. That said, we’d note that over the last five years, reported earnings have come in, on average, 4.2% above consensus expectations. If history is consistent, this would put the actual third quarter earnings growth rate around 7%, a much more respectable level given the circumstances.
Regardless of where the actual growth rate shakes-out, we believe the underlying fundamentals continue to improve. This is supported by expanding margins during a comparatively unimpressive growth quarter. The net margin (the amount of income a company earns on each dollar of revenue after taxes are stripped out) for S&P 500 companies is expected to widen to 9.49% in the third quarter, yet another record. That level of corporate profitability is up almost a full percentage point relative to last quarter and the same period of 2016, with only some of the improvement the result of a weak US dollar. To us, this is clear evidence the growth outlook will be much more robust going forward and the “lull” is just temporary due primarily to unforeseeable factors.
This quarterly earnings season is a friendly reminder that earnings are backward-looking, while stocks are forward-looking. This means the market is likely to eventually brush off meager earnings growth in the face of accelerating outlooks. Currently, Wall Street analysts expect 11.1% year-over-year earnings growth in the fourth quarter, a rebound that we think is likely to continue well into 2018. While there are always upside and downside macroeconomic risks, these earnings forecasts keep us bullish on the fundamentals of our portfolio and on the markets.
Does a Bond Bubble Mean Portfolio Trouble?
Many investors think that bonds are a necessary component to every portfolio. In the current market environment, Catamount has a more nuanced view.
How low can rates go and what it means for bonds in your portfolio:
Interest rates and bond prices move in opposite directions. As rates increase, bond prices decrease. Investors flock away from old bonds and towards newer bonds with higher coupons. Rates are currently near all-time lows and are expected to increase. This means that your upside is limited (if rates are low, the coupon payments from your bonds will be low) and that the downside is relatively high (as rates increase, existing bonds will decrease in value on the secondary market).* Even Alan Greenspan, the famous former chairman of the Fed, thinks that the bond market is currently in a bubble.
Dividend stocks as an alternative:
In the current market, we think stocks that pay out a dividend are a great alternative to bonds. They provide investors with income that can match that of bonds in some cases, but also allow for some of the upside of the equity markets. As a real-world example, let’s take a company in the Catamount portfolio that has highly-rated, investment grade bonds: Unilever (NYSE: UL). In the last year, one share of UL has paid out a dividend that is effectively 3.1% of the price of the stock a year ago. It has also seen an incredible stock price surge of 25%. If you had instead purchased a bond issued by Unilever, you would have lost 2.2% of the amount you invested. For some more nitty gritty detail, see the Appendix.
How we got to today:
After the 2008 market crash, prime interest rates were lowered to effectively zero. To put the period in historical perspective, below is a chart of the federal funds rate encompassing more than six decades. Recessions are highlighted in grey. To boost the economy out of a recession, the Fed will generally lower interest rates to stimulate the economy. As the economy heats up, the Fed will raise rates to cool things down and temper inflationary pressures on prices.
Federal Funds Rate 1954 to Present
What is amazing about the graph above is that the Federal Funds Rate was above 20% in the 80’s but is now only about 1%. As Big Lou likes to say, if we were in the 1980’s again, we would have a portfolio full of bonds.
What this means for bonds and your portfolio:
This means that return on bonds you can buy in your portfolio are historically very low. In the mid-1990s, highly-rated bonds (Moody’s Aaa rated bonds for instance), would yield 7.5% – 8.5%. This September, those same bonds have a yield of just 3.6%. With rates expected to rise, your returns on those bonds could be even worse.*
Should I sell my bonds?
The answer is not an automatic “yes”, or “no”. At Catamount we understand that each investor and each portfolio has specific needs. With highly-rated bonds do not generate as much income as they did in the 1990s. Investors looking for income from their bonds should consider this. If you look to riskier bonds that have higher returns, you run the risk of default. This can be seen with the recent bankruptcy bid by Puerto Rico that encompasses $70 billion of debt. On the other hand, if 3-4% income fits your portfolio’s needs, you should absolutely own bonds.
Every investment has a risk and reward tradeoff. In the current market environment, we think that investors should look at dividend yielding equities to as they consider income in their portfolio.
*Note: A standard bond will repay its principal in full (so long as it there is no default). This statement reflects the secondary market where bonds are traded and prices of a bond can move daily.
After Disney’s recent announcement about building a pair of video streaming services – one is an ESPN-branded platform and the other is Disney-branded – to accelerate its “direct-to-consumer” initiative, there has been an uptick of chatter over cord-cutting in the news. The topic is getting almost as many hits as ‘John B. McLemore’ when the S-Town podcast premiered in March or when the Dothraki crossed the Narrow Sea. Although Disney currently holds the spotlight, the shift to streaming has been in the works for well-over a decade, and it was (surprisingly) CBS who deserves credit as the true trailblazer among large media after All-Access was launched back in 2014.
This cord-cutting trend should come as no surprise given that nearly two-thirds of all households in the U.S. subscribe to a service like Netflix, Amazon Prime or Hulu, up from less than 50% three years ago. In addition to the aforementioned “streamers,” Facebook, YouTube and even Twitter are offering live streaming options, while virtual pay-TV providers like Sling make switching extremely affordable for customers uninterested in traditional plans.
In essence, cord-cutting is truly just beginning as households start to question why they’re overpaying for cable, especially when considering the average household doesn’t view over 90% of the channels to which they have access, and recognizing that their monthly charges have risen too quickly. For example, the average household paid $100 a month to cable companies in 2016 compared to just $70 in 2011, a 43% increase or 6X the inflation rate!
While cord-cutting is not a new phenomenon, it really started to accelerate in 2016 after 1.9 million pay-TV customers cancelled their contracts. Prior to last year, the attrition rate was around 1 million a year. This higher pace is expected to continue as media think-tanks estimate that at least 10 million more customers will follow suit over the next 5 years. As a result, M&A within media has been a common theme throughout 2017; AT&T is acquiring Time Warner, Sinclair – one of the country’s biggest local television station owners – is in the process to buy Tribune and Starz was approved to be taken-out by The Hunger Games and La La Land producer, Lionsgate. This consolidation likely continues.
Part of the draw beyond availability is due to the better quality of content being developed by streaming providers with shows such as Westworld, House of Cards, Orange is the New Black, Transparent and Ozark (Catamount’s newest obsession on Netflix – hop on the train, people! Another suggestion that will not disappoint: The Jinx on HBO. Anyway, we digress…). And have you heard that Shonda Rhimes, Grey’s Anatomy and Scandal producer for ABC, is bringing her creativity to Netflix after being with the network for 15 years? This move potentially raises the bar even further. Perhaps we should all get more comfortable couches.
We’re in the midst of a media boom today and the most obvious winners from this dynamic will be consumers as Americans still have a habit of sitting in front of the television. With the explosion of high quality content and more outlets to view the next hit show about vampires or a behind-the-scenes documentary featuring René Redzepi’s next Danish creation (can one of our readers please make this happen?), media companies have recognized that the model needs to evolve. Unfortunately, we are still a long way from seeing how it settles beyond plain, old “bundling.”
The next buzzword to watch for in media? Cord-nevers. You heard it here first.
Many investors look to oil stocks for dividend payouts and view these stocks as conservative investments. It is important to understand what moves these stocks and what that can mean for your portfolio. Oil stock performance is highly correlated with the price of oil. Oil itself is a commodity that is subject to complex, and often sudden external forces. For instance, in the 19 months from June 2014 to January 2016, the price of oil dropped 75%. Major oil stocks lost about 30% of their value while the S&P 500 only dropped 8%. The forces behind that price movement have changed the dynamics in the oil market forever. We will dive into these dynamics further later in this post.
Oil companies around the globe are adjusting to a new normal in a price environment that experts have called “lower for longer”. Many companies, especially large US operators, have survived the downturn and regained sales and profitability. However, the stock market has not rewarded them. Given the lower correlation to the stock market generally (e.g. stock prices that move as oil moves, and less along the lines of the general market), these stocks add value in diversifying a portfolio. That said, investors should also consider other traditional conservative sectors like consumer staples and defense to build a properly rounded portfolio. Catamount has representatives from each of these sectors in our portfolio.
OPEC gives way to US producers
Let’s start with a bit of history to give better context for the most recent changes in the market. Since the mid-1960s, OPEC, an organization of oil producing states, has tried to bring calm to the oil markets by regulating the production of its members. It maintained this power because it was comprised of the global “swing producers”. These countries could effectively turn the tap “on” or “off” at their convenience. While this arrangement has been disturbed by geopolitical disputes from time to time, most spare oil production capacity remained in OPEC’s control.
However, technological advances in areas like “fracking” and relaxed environmental policies enabled the United States to nearly double oil production from 2008 to 2015. In effect, the US became the swing producer for oil. This growth in production led to a glut of oil in the marketplace. As a result, prices plummeted. Instead of cutting production, OPEC allowed the glut to continue to drive higher-cost producers in the US out of business. This strategy worked to some extent, with around 100 US-based oil and gas companies going bankrupt. However, most all major US producers emerged leaner and lower-cost than ever.
Fast forward to today. Over the last year, oil prices have been bouncing around between $45 and $55 per barrel, without breaking out in either direction. In that same time, the largest US independent oil producers have turned earnings from negative to positive, and about doubled revenues. Despite incredibly positive fundamental rebound, and general upswing in equity markets, only a few have outperformed the S&P 500.
What does the future hold for oil?
Looking to the future, even the Middle Eastern oil titans appear to have a bearish sentiment. The man who founded modern day Dubai once said, “My grandfather rode a camel, my father rode a camel, I drive a Mercedes, my son drives a Land Rover, his son will drive a Land Rover, but his son will ride a camel.” That man’s name was Rashid bin Saeed Al Maktoum. This quote reflects a commonly held view that even though oil can bring about tremendous wealth, that wealth will only last a few generations. Dubai has actively sought to diversify its economy away from oil and has become an economic powerhouse by investing oil dollars in trading infrastructure. Saudi Aramco, the state-owned oil company of Saudi Arabia that also represents the largest oil company on the planet, has announced plans to IPO and plans to diversify away from oil starting in 2018. You can see similar public diversification plans announced recently in Egypt, Qatar, UAE, and Oman.
Electric cars are a strong headwind here as well. While not all of oil goes into fuel (some goes into plastics and other chemical products), a good portion of it does. In the US, about two thirds of the petroleum products consumed are in the form of fuels that could be replaced by electric vehicles. Goldman Sachs predicted that by 2025, 25% of cars will have electric engines. Major car producers around the world are moving towards electric vehicles. Whether it is the all-electric Tesla models in the US, or Volvo vowing to make non-petroleum cars by 2019, the future is looking dimmer for oil. Additionally, Britain recently vowed to ban diesel and petroleum cars by 2040.
How does this fit into Catamount’s strategy?
In summary, there are strong headwinds in the long term for oil. While oil stocks can be valuable in a portfolio from a diversification and dividend perspective, it is important to look at other sectors that can also add these characteristics to your portfolio. At Catamount, we have some exposure to oil, but also to other conservative, dividend paying stocks like those in consumer staples and defense. Considering the challenges facing oil and gas going forward, we are also closely monitoring new energy technologies like renewables, energy efficiency, and energy storage. More to come on these sectors…
What is the 4% Rule and Should I Use It?
What is the 4% rule and should I use it? These are questions we hear often from clients and potential clients. The 4% rule was created by William Bengen in the 1990s. After research into historical rates of return on stocks and bonds, Bengen concluded that 4% was the largest annual withdrawal rate one could exercise on their savings if they wanted their savings to last for 30 or more years. The idea is that in the first year of retirement, one would withdraw 4% of aggregate savings and then each following year increase this withdrawal number in direct proportion to inflation. For example, if a couple has $1,000,000 in savings and inflation is 2% a year, they would withdraw $40,000 (4% of their savings) in their first year of retirement, and $44,800 the second year and so on.
So should you use the 4% rule? Is it too ambitious? Is it too conservative?
Many Financial Advisors think that a 4% annual withdrawal rate is in fact too ambitious and that a 3% rate is more appropriate for most retirees. Sure, a 3% annual withdrawal rate means less cash to spend every year than a 4% rate, but it also provides a higher level of assurance that a retiree’s savings won’t run out prematurely – and what could be worse than that?
However, other Financial Advisors, such as Michael Kitces, are quick to point out that there has not been 30-year period over the past 150 years in which a retiree employing the 4% rule would have run out of money. Instead, Kitces notes that about two thirds of the time one employing the 4% rule would end up with more than double their original principal!
What does the future hold? How will markets perform? No one knows and, yes, it is possible to encounter a 30 year period in which a retiree following the 4% rule would run out of money.
Ultimately, it is nearly impossible to accurately forecast a perfect withdrawal rate that would both protect a retiree against the risk of running out of money without also leaving him open to the risk of ending up with more savings than he needs later in life. At Catamount, we understand that your situation is unique and that you can’t always rely on a simple formula to guide your retirement plan. Together, we can establish and continually adjust your withdrawal rate so that it meets your needs and ensures you won’t outlive your money. We would be excited to help you start planning for your retirement today! Please contact us for more information or any questions you might have. We are always happy to chat. firstname.lastname@example.org, or 203.226.0603.
Are Bonds Really Safer Than Stocks?
It is commonly perceived that bonds are a “safer” asset class than stocks. We come across this perception in conversation with clients, potential clients, and sometimes even with peers in the wealth management industry. How many times have we heard the words “safe” and “bond” in the same sentence? But bonds are not always safe. In this post, we will illustrate risks inherent in bond investing and market dynamics to beware of.
Bonds have four primary attributes to consider:
- Principal/Par Value – This is the amount of money that will be paid out once the bond matures. A newly issued bond usually sells at the par value.
- Coupon – This is the amount of money the bondholder receives as interest payments.
- Price – This is the bond’s current price in the market.
- Yield – Yield is a figure that shows the return you get on a bond. The simplest version of yield is calculated using the following formula: yield = coupon amount/price. When you buy a bond at par, yield is equal to the interest rate. When the price changes, so does the yield.
Let’s demonstrate this with an example. If you buy a bond with a 10% coupon at its $1,000 par value, the yield is 10% ($100/$1,000). Pretty simple stuff. But if the price goes down to $800, then the yield goes up to 12.5%. This happens because you are getting the same guaranteed $100 on an asset that is worth $800 ($100/$800). Conversely, if the bond goes up in price to $1,200, the yield shrinks to 8.33% ($100/$1,200).i
The prospect or expectation of rising interest rates, which we face during 2017, is one market dynamic that makes bonds a less attractive and even risky investment. Bond prices and interest rates have an inverse relationship – when interest rates rise, bond prices fall. This inverse relationship may seem counterintuitive, but after consideration it makes sense. When interest rates rise and new bonds are issued, the new bonds will have a higher coupon rate than the previously issued bonds – this creates a dynamic where the yield on older bonds is no longer competitive or attractive because it is lower than the yield on new bonds; in order compete with the newly issued bonds, prices fall across older bonds until their yield is on par with the newer bonds. That is a lot of information to digest, so consider the following simple example.
Imagine if we were to buy a bond today with a 10% coupon for $1,000 – this bond would pay $100 and the yield would be 10% ($100/$1,000). And then in a year, interest rates doubled and newly issued bonds had a 20% coupon with the same $1,000 principal. These new bonds would make our old bond less attractive because they pay twice as much! To remain competitive in the market, the price of our older bond would have to drop to $500 for its yield to reach 20% ($100/$500). Ultimately, our recently purchased $1,000 principal bond would be worth $500 – a 50% loss on our investment.
Inflation can both directly and indirectly effect bond prices. During periods of high inflation, the Federal Reserve will often raise interest rates to tighten the money supply and curb inflation. As we now know, interest rates and bond prices have an inverse relationship and a rise in interest rates pushes bond prices down; in this case, inflation is indirectly having a negative effect on bond prices. More directly, inflation reduces the purchasing power of a bond’s coupon payments and its overall yield. For example, consider the performance of a short-term bond that yields 1% over the course of a year with 4% inflation, this bond will yield a 1% nominal return but when you adjust for inflation, the bond will yield a -3% real return.
Finally, it is important to consider default risk and trading liquidity. Although these are typically not large risks in treasury or municipal bond investing, they exist across corporate and high yield bond investing. When a corporate bond is purchased, the purchaser is ultimately reliant on the respective corporation’s ability to pay the interest payments and, eventually, the principal; sometimes, due to unforeseen economic circumstances or poor performance, payback isn’t possible and the loans are defaulted. It is also important to consider trading liquidity, as corporate bonds often trade at low daily volumes. Low trading volumes make it hard to get out of positions, and this dynamic can push prices down.
If you have any questions about this post or bonds in general, please reach out! Thanks for reading and please share this post.