Tag Archives: loans

Do You Have Rally Envy Or Bear Market Anxiety?

For those who have paid attention, the last actual bond purchase by the Federal Reserve occurred on December 18, 2014. Why does the date matter? For one thing, research demonstrated that the expansion and manipulation of the Fed’s balance sheet (i.e., QE1, QE2, Operation Twist, QE3) corresponded to 93% of the current bull market’s gains . 93%! Secondly, stocks have struggled to make any tangible progress since the central bank of the United States ended six years of unconventional monetary policy intervention roughly 18 months ago. If you subscribe to the notion that the Fed’s balance sheet is – for all purposes and intents – the primary driver for asset price inflation, you probably have a substantial money market position already. Perhaps you have moved 20%, 25% or 30% to cash or cash equivalents. On the other hand, if you simply believe that low interest rates alone “justify” exorbitant valuation premiums , you may be content to ride out any volatility in an aggressive mix of stocks of all sizes and higher-yielding instruments. Myself? I believe that recent history (20-plus years) as well as long-term historical data (100-plus years) favor a defensive posture. For instance, in the 20-year period between 1936-1955, there were four stock bears with 20%-40% price depreciation and ultra-low borrowing costs near where they are today. Interest rate excuses notwithstanding, every prior historical moment where there were similar extremes in stock valuations – 1901, 1906, 1929, 1938, 1973, 2000, 2007, stocks lost more than 40% from the top. There’s more. Since the mid-1990s, peak earnings have been associated with eventual market downfalls. Near the end of 2000, the S&P 500 traded sideways for nearly a year-and-a-half; shortly thereafter, the popular benchmark collapsed for a top-to-bottom decline of 50%. In the same vein, the S&P 500 had been in the process of trading sideways for approximately 18 months near the end of 2007; thereafter, U.S. stocks lost half of their value alongside a peak in corporate profits. With corporate profits having peaked near the tail end of 2014, and with the S&P 500 range-bound since the tail end of 2014, is it reasonable to suspect that history might rhyme? Click to enlarge In light of what we know about valuations and corporate debt levels , bullishness on markets moving meaningfully higher would depend heavily on three items: (1) Profits per share must improve in the 2nd half of 2016 alongside stability in oil as well as improvement in the global economy, (2) Corporations must continue to borrow at low rates to finance the purchase of stock shares that pensions, retail investors, hedge funds and institutional advisers are unlikely to acquire, and (3) Corporations must have the access to borrowed dollars in an environment where lenders do not choose to tighten their standards. On the first point, there have been exceptionally modest signs that the euro-zone economy is picking up marginally. On the flip side, emerging market economies, particularly China and Brazil, are still deteriorating, while Japan appears to be coming apart at the seams. The net result? I expect a wash. It is difficult to imagine genuine profitability gains based on a global economic backdrop as murky as the one we have at present. That said, companies will still want to enhance their bottom lines. The only way that they’ve been able to do it since the 3rd quarter of 2014? Borrow money at low rates, then acquire stock to lower the number of shares in existence. Not only does the activity boost earnings per share (EPS) when there are fewer shares, but the reduction in supply makes shares more scarce. Scarcity can artificially boost demand. However, what would happen if it became more difficult for corporations to tap the bond market to finance buyback desires? Indeed, we may be seeing the earliest signs already. Consider a reality that the most recent data on commercial and industrial loans (C&I Loans Q4 2015) revealed where lending standards tightened for the third consecutive quarter. Some research has even shown that when there are two consecutive quarters of tighter lending standards, the probability of recession and/or a significant default cycle increases dramatically. (And we just experienced three consecutive quarters.) It is equally disconcerting to see how this has played out for financial stocks where banks tend to be exposed to “undesirable” debts. There’s no doubt that the Financial Select Sector SPDR ETF (NYSEARCA: XLF ) had a monster bounce off of the February 11 lows. On the other hand, the downward slope of the long-term moving average (200-day) coupled with an inability to gain genuine traction over the prior nine months is unhealthy. The same concerns exist in European financial companies via the iShares MSCI Europe Financials Sector Index ETF (NASDAQ: EUFN ). One thing appears certain. With respect to the stock market itself, quantitative easing (QE), zero percent rate policy (ZIRP) and negative interest rate policy (NIRP) primarily enticed companies to act aggressively in the purchase of additional stock. “Mom-n-pop” retail? They’re not biting. Neither are pensions, “hedgies,” money managers or other institutional players. Only the corporations themselves. So what would happen if corporations – entities that have already doubled their total debt levels since the end of the Great Recession – significantly slowed their borrowing? Don’t discount it! Executives may already be growing wary about their corporate debt levels; they may already be troubled by the underperformance of stock shares after having spent billions on buybacks. In fact, a borrowing slowdown could occur because access to credit becomes more difficult. Personally, I recognize that the Fed is unwilling to sit on its backside if a bearish downtrend escalates. In fact, I have already laid out the scenario as I anticipate it occurring; that is, we travel from 4 rate hikes in 2016, to 2 rate hikes to no rate hikes to QE4 . Some do not believe that a fourth iteration of quantitative easing would stop a bear in its tracks, but I think it could reflate assets significantly. (And that’s not an endorsement of QE, only a recognition of its success at fostering indiscriminate risk taking in the current cycle.) On the flip side, I cannot say when the Fed will resort to QE4. Most likely? They’d hint at a shock-n-awe policy action near 1705 on the S&P 500. Until the Fed gives financial speculators what they want, though, I plan to maintain an asset mix for clients that is more defensive than usual. Could you have any exposure to Vanguard Total Stock Market ETF (NYSEARCA: VTI )? Sure. Nevertheless, you’ll need 25% in cash/cash equivalents to take advantage of a bear-like mauling. Click here for Gary’s latest podcast. Disclosure: Gary Gordon, MS, CFP is the president of Pacific Park Financial, Inc., a Registered Investment Adviser with the SEC. Gary Gordon, Pacific Park Financial, Inc, and/or its clients may hold positions in the ETFs, mutual funds, and/or any investment asset mentioned above. The commentary does not constitute individualized investment advice. The opinions offered herein are not personalized recommendations to buy, sell or hold securities. At times, issuers of exchange-traded products compensate Pacific Park Financial, Inc. or its subsidiaries for advertising at the ETF Expert web site. ETF Expert content is created independently of any advertising relationships.

Loans, Write-Downs And Shares…Oh My!

My family and I recently went to see the musical Wicked . Having already been with my wife when it first opened in 2003, I was thrilled to relive the awesome and spine-tingling performance with my kids. The creative genius of Wicked is its backstory – the plot that no one hears throughout the Wonderful Wizard of Oz . Turns out, the wizard isn’t really all that wonderful, and the witch isn’t so wicked after all. This got me thinking about parallels to the world of finance and how things aren’t always as they seem. We all know that the S&P/TSX Composite Index is heavily skewed toward the financials (37%), energy (20%) and materials (12%) sectors, but attitudes towards these industries have become rather split lately. In the past few years, financials have been all aglow thanks to consistently improving quarterly results, whereas the resource sectors have been a source of pain amid lower earnings, dividend cuts and write-downs. While faith in the financial sector may be justified, investors might not realize just how dependent the Canadian stock market has become on its earnings and dividends. According to data compiled by Bloomberg, while financials make up more than a third of the market cap, the sector accounts for more than 50% of the earnings and slightly less than half of the dividends paid on the S&P/TSX Composite Index. Click to enlarge Something wicked this way comes? Outsized dependencies are rarely a good thing in investment portfolios. For example, in the late 1990’s investors became overly dependent on technology companies trading at ever higher multiples, and then found themselves in a post-financial-crisis love affair with emerging markets. In both of these cases, investors paid too little attention to the backstory: technology had become more than a third of the S&P 500 and paid no earnings, and emerging markets had become reliant on leverage and an ever-expanding China. Investors also became overly dependent on U.S. financials a decade ago when the sector contributed more than 50% of the S&P 500’s earnings and dividends in 2006 only to fall off a cliff when the financial crisis hit two years later. The financial sector also grew to almost a quarter of the listed market in 2006, well above today’s level of 17% (still high but just not as high). Does this mean Canadian financials are due for some sort of rude awakening? Not necessarily. It depends on whether Canadian banks will report more bad loans and will have to incur larger write-downs than are currently reflected in loan loss provisioning or the share price. Intuitively, the nearly 70% decline in oil prices over the past two years and the broadening difficulties in the Canadian energy patch would imply a greater risk of loan defaults. Moreover, banks could see declining revenue growth and weaker revenues as the indirect consequences of low oil prices work through the extensive supply chain. But for now, these worries are the backstory. Canadian share prices are following the lead story: The banks’ exposures are manageable, the banks are prepared, and they continue to stress-test their loan book. Importantly, investors should know what their exposures are. Right now, investors in Canadian stocks are highly dependent on earnings and dividends from the big banks. If Canadian financials were to dip, investors could be in for a rude awakening. With any luck, the energy and materials stocks won’t seem as wicked if the rise in commodity prices in recent weeks supports upward earnings revisions in the next few quarters. The best outcome for reducing dependency on the financials is growing earnings from other sectors, not falling earnings from the banks. What can Canadian investors do to help reduce dependencies and limit outsized domestic exposures to the financial, energy and materials sectors? I would recommend considering allocations to two sectors that are underrepresented in the Canadian equity markets, such as global healthcare and technology, where there has been better dividend growth and stronger secular growth trends. Source: Bloomberg. This post originally appeared on the BlackRock Blog

ETF Relationships That May Tell You When The Worst Is Over

Businesses, consumers and the federal government have taken on enormous amounts of debt since the Great Recession. Optimists argue that total debt is irrelevant; that is, they believe the only thing that matters is the cost of servicing those debts. Fair enough. Then what happens when interest expense does rise? Assuming total debt remains the same, higher rates would increase the percentage of household income or the percentage of corporate/government revenue that must be allocated to debt servicing. In earlier commentary, I provided data showing how the total debt of corporations has DOUBLED since 2007. Thanks to seven years of zero percent rate policy, alongside a number of iterations of quantitative easing (QE), the average rate on corporate debt is down from eight years ago. More critically, however, average interest expense has risen substantially . That’s right. Corporations need to assign more and more of their “gross” toward paying back the interest on their loans. What about households? Well, we’re back to the 2007 record debt level of $14.1 trillion in mortgages, credit cards, auto loans, student loans and credit cards; the typical household has nearly $130,000 in total debt. The good news? Years of stimulative monetary policy has made it easier for households to service these debts. The bad news? Americans “re-leveraged” rather than “de-leveraged.” Any amount of rate hike activity would damage the ability of average Americans to borrow-n-spend. In fact, recent retail data demonstrate just how little Americans feel they have left over to spend, in spite of massive savings at the gas pump. Traditional home affordability measures like median sales price-median income illustrate just how dependent we are on ultra-low interest rates. Specifically, the historical home price-to-household income ratio is 2.6. Where are we at today? Back near the housing bubble highs of 4.0. It certainly does not get any better if one looks at U.S. government obligations. The national debt is roughly $19 trillion, excluding the country’s unfunded liabilities (e.g., Social Security, Medicare, Medicare prescription drug program, federal pensions, etc.). According to Dave Walker, the former head of the Government Accountability Office (NYSE: GAO ) under Presidents George W. Bush and Bill Clinton, the national debt is closer to $65 trillion, including unfunded liabilities. Does anyone believe that those numbers are going to get smaller? Or even, heaven forbid, remain the same? In other words, rising interest expense or rising debt levels would make it even more difficult for the government to honor its obligations. Is it any wonder, then, how schizophrenic riskier assets are? It is the direction of the Fed’s rate normalization path – no matter how gradual – that has nudged the bear out of hibernation . China? Its slowing economy adversely affects corporate profits, but it’s the Fed’s perceived reluctance to “save stocks” that has agitated market participants. Oil? Its rapid-fire descent highlights the possibility of a worldwide recession, though it is the Federal Reserve’s disinclination to “step in” that is rocking investor confidence. Fortunately, there are a number of ETF relationships that can help a cash-heavy investor identify when things may be getting better. More precisely, when “risk-off” relationships abate, one may feel more upbeat about shifting from a mode of capital preservation to a mode of wealth accumulation. Consider the relationship between gold and oil. When people prefer the precious metal to the natural resource, they are expressing a preservation preference. And vice versa. When investors speculate that oil prices will rise, they are typically expressing confidence in the growth of the global economy. It follows that the SPDR Gold Trust ETF (NYSEARCA: GLD ) : The United States Oil ETF, LP (NYSEARCA: USO ) price ratio is likely to climb in troubling times; it is likely to spike in panicky stock sell-offs. One might wish to see the slope of the GLD:USO 200-day moving average flatten out – and the GLD:USO price settle down a bit – prior to making huge commitments to riskier assets. Granted, the rapid depreciation of oil itself has had a fair amount to do with the general trend of GLD:USO. Nevertheless, all three of the most recent corrective phases in U.S. stocks – October of 2014, August-September of 2015, January of 2016 – dovetail perfectly with spikes in GLD:USO. In the same vein, the flattening of the yield curve tells market watchers that participants are concerned about recession probabilities. The difference between the 10-year Treasury bond yield and the 2-year Treasury bond yield has fallen to lows that we haven’t seen since the Fed shocked-n-awed the world with its most powerful stimulus ever, QE3. Of course, some folks prefer to remain in the world of specific ETF assets as well as rising/falling price ratio relationships. For those investors, I suggest that they track the iShares 7-10 Year Treasury Bond ETF (NYSEARCA: IEF ):iShares 1-3 Year Treasury Bond ETF (NYSEARCA: SHY ) price ratio. A rising price ratio implies that people are seeking safety in the middle of the yield curve, while others may be avoiding the short end of the yield curve due to Federal Reserve rate hike intentions. Thus, the yield curve is flattening when IEF:SHY is rising. Since the stock market highs in July, IEF:SHY has, for the most part, been on a steady path higher. A sustained reversal in this trend would be an indication that investors are growing more comfortable with the health of the domestic economy. Disclosure: Gary Gordon, MS, CFP is the president of Pacific Park Financial, Inc., a Registered Investment Adviser with the SEC. Gary Gordon, Pacific Park Financial, Inc, and/or its clients may hold positions in the ETFs, mutual funds, and/or any investment asset mentioned above. The commentary does not constitute individualized investment advice. The opinions offered herein are not personalized recommendations to buy, sell or hold securities. At times, issuers of exchange-traded products compensate Pacific Park Financial, Inc. or its subsidiaries for advertising at the ETF Expert web site. ETF Expert content is created independently of any advertising relationships.