“We Have Reached Our Cruising Altitude”

May 2, 2017 | Print View

Those are always comforting words when flying. The pilot will usually follow up with a comment about turning off the seatbelt light and telling passengers they are free to move about the cabin. There is usually a safety recommendation to keep the seatbelt fastened while seated. In the stock and bond markets it feels like we have reached our cruising altitude, but we advise that you keep your seatbelts fastened in case we hit some unexpected turbulence.

In April, the stock market leveled off at a comfortable altitude. A French preliminary election and a new round of quarterly corporate earnings brought us back to the 21,000 level on the Dow Jones Industrial Average. All the noise regarding Syria, North Korea, trade wars, walls, immigration, tax cuts, Obamacare, and shutting down the federal government can be a distraction to what really matters: corporate earnings. Thankfully, the market has not lost its focus. Strong earnings from McDonald’s, Alcoa, Caterpillar, and DuPont were welcome news and signaled that another quarter of solid earnings is on the way. The technology sector fueled the Nasdaq Composite to breach the 6,000 milestone with Facebook, Netflix and Google (now Alphabet) reaching records highs. International stocks are back in play as the news from France ignited a rally overseas. At the end of the month, it was the international developed stock group taking home the first place trophy with a return of 2.54% followed closely by the NASDAQ Composite and emerging market stocks with monthly returns of 2.35% and 2.19%, respectively.

Since our elections last fall, the market has moved steadily higher with volatility nearing record lows. This is not uncommon as a smooth ride keeps investors comfortable. This feeling of calm will not last forever, but take the time to enjoy it. Graphically, this 10-year chart of volatility speaks volumes about the underlying positive tone in the market:

The bond market continues to befuddle experts as interest rates appear to have a mind of their own. The 10-year U.S. Treasury Note traded in a range of 2.4% to 2.2% during April and finished the month yielding 2.3%. There are some interesting dynamics at work in both the U.S. and international bonds markets. Interest rates throughout the developed world are low and continue to remain low. In the U.S., we tend to compare the yield of the 10-year U.S. Treasury Note to where it’s been over the past 10-15 years, and we can accurately state that our interest rates are low. When you take the next step and compare our 2.3% yield on 10-year to Germany at 0.3% or France at 0.8% or Japan at 0.0%, you begin to realize our interest rates are quite attractive in a global sense. While the consensus is for higher interest rates in the U.S., getting there will be slowed by global factors destined to keep interest rates low.

Stay positive with your investment program and enjoy the ride. Asset prices will correct at some point in the future, but for the present time we are in a sweet spot of positive corporate earnings, low interest rates and low volatility.

MARKETS BY THE NUMBERS:

Past Market Commentary by Wayne Schmidt

Let’s focus on the markets. In February, the bull market in U.S. stocks continued its run to levels never before seen. Dow 20,000, once an unreachable peak is now 812 points in the rear view mirror and Dow 21,000 is knocking on the door. It was a remarkable month for stocks with only five down days and twelve consecutive record breaking closes for the Dow. Market leadership came from the consumer goods, healthcare, and financial sectors. Apple was the one thousand pound gorilla in the room, gaining an amazing 12.8% in the short month. Healthcare was led by Pfizer and Johnson and Johnson with returns just below 10%. Banks had a solid month across the board as the prospects of higher interest rates would improve net interest margins and the proposed peel back in regulation provided additional fuel for their rally. Basic materials took a breather led by declines in some of the major oil companies like Exxon which was down just over 4%. The U.S. stock market as measured by the S&P 500 gained 3.97% in February, outpacing the emerging markets and international markets which returned 3.06% and 1.43% respectively.

Interest rates, which have gone absolutely nowhere this year, should begin to drift higher as the economy continues to grow and Washington discovers fiscal policy once again. Fiscal policy is important to the Federal Reserve because it provides them more latitude to implement a more restrictive monetary policy. Chairwomen Janet Yellen made clear in testimony to Congress that rate hikes are “on the table” for their March meeting and I imagine each Fed meeting this year. The Fed needs to return to a normalized monetary policy before they can begin addressing their bloated $4.5 trillion balance sheet. The Fed has a long way to go and raising the Fed Funds rate is just the beginning.

Higher interest rates mean lower bond prices. Time also plays an important role in bond price action. We believe the rate rise this year will be gradual. This means the income earned from bonds over the course of the year will have the opportunity to cushion the price decline. This path is less painful than an immediate rise in interest rates which causes a sudden price decline. In this scenario, investors need twelve months of income to repair the effects of a sudden rate increase. It’s okay to own bonds for the basic reasons of income, principal preservation or volatility control, but temper your expectations from this asset class. Earning the coupon alone would make for a great year in bonds.

Whether your t-shirt reads, “Make America Great Again” or “Dump Trump”, please check it at the door and embrace the financial markets on their own merits. As explained in last month’s commentary, we are positive on the global stock markets in 2017 and cautious on the outlook for bonds. The path will not be a straight line higher, rather periods of strength followed by consolidations as news and revised expectations are priced into the markets. If watching cable news is now a hobby, either embrace the perceived chaos you hear every night or change channels if your market view is being swayed. Nothing trumps a solid financial plan. Stay on your path.

MARKETS BY THE NUMBERS:

Yes, the stock market continues to trade near all-time highs and a temporary early year price consolidation would not be a surprise. Equally possible is the scenario where the train continues to pull away from the station as new pro-growth policies and potentially lower corporate taxes benefit stock prices. The fundamental facts as we see them show stable to expanding core economic growth through 2018. Future growth in the 2-3% range will push the stock market higher. At the heart of the fundamental story is an acceleration of corporate earnings. The stock market navigated the deceleration of earnings growth and now we enter a more positive earnings phase. Remember, its earnings and valuation that drive stock prices. Positive earnings will be a positive force.

We see the U.S. stock market generating positive returns in the 5-10% range for the calendar year. Experience tells us the path to high single digit returns is not a gentle sloping line, rather a series of rallies and subsequent pullbacks. This year may in fact look like last year’s price action with new reasons for periods of price consolidations. Below is the 2016 path traveled.

If stocks are up 5-10%, what happens to bonds? The bond market is entering a new phase as the Federal Reserve’s seven year zero interest rate policy is coming to a close. Interest rates will begin an orderly move higher lead by the short end of the yield curve. The Federal Reserve now has room to begin the process of normalizing monetary policy. While the Fed has threatened for two years to embark on a systematic plan to hike the fed funds rate, we believe this is the year where it really begins. Three or four quarter point rate hikes will leave the fed funds rate near 1.50% by the end of the year.

The journey to higher interest rates will cause bond prices to decline and returns to be skimpy in 2017. Flat is our call, but plus or minus a few percentage points can easily occur. Investors should still own bonds for reasons of principal preservation, income generation or for overall portfolio volatility control, but realize this is not an asset class to make you rich this year. After higher interest rates are achieved, bonds will offer a more compelling future value. Bottom line in 2017 is, “don’t expect much offense from your bond portfolio”.

Every time period deals with market volatility and uncertainty. The markets have survived two World Wars, the great depression, stagflation, an oil crisis, the internet bubble and a financial crisis. This time is no different as the weight of the world can cause rational investors to second guess their investment decisions. This a dangerous trap to fall into, so be strong and avoid the temptation to eliminate risk. Risk makes you wealthy. Traveling through your investment horizon with confidence, conviction and patience is hard work, but the rewards are great. Five years from now, it will not matter if the market is up or down 5% in the next few months. Stay long and strong for the long haul.

MARKETS BY THE NUMBERS:

The year got off to a rough start as major stock indices were down double digits, reaching their eventual low water mark for the year. The Dow Jones Industrial Average bottomed at 15,450, the S&P 500 hit 1,810, the yield on the 10-year U.S. Treasury was 1.63% and oil was $26.19 per barrel. Fast forward to the post-election euphoria and we almost saw Dow 20,000, the S&P 500 hit 2,270, the 10-year U.S. Treasury yield north of 2.50% and the price of a barrel of WTI crude settled in the $50 area. What a difference 10 short months can make.

The election provided a new coach with a new playbook. The market obviously likes what it is hearing, but the new team has not taken the field yet. The new playbook has plans to be pro-business with lower taxes, less regulations, reformed health care, energy independence and a keen focus on growth and jobs. The plan on paper looks great, but it still needs to be executed on the field with opponents fighting hard at every turn. The market has given us a glimpse of what could be, but keep in mind the market will eventually trade on what will be.

After a gut wrenching start, stocks turned the corner and produced solid returns this year. The Dow Jones Industrial Average gained 16.50% for the year, the S&P 500 was up 11.96%, and Emerging Markets delivered 11.19%, while MSCI EAFE added just 1.00%. The big stories for stocks this year was the turnaround in oil prices, low interest rates and the beginning of an earnings recovery. The prospect of a new pro-growth political environment added to the bullish momentum.

Bonds generally moved in opposite directions from stocks this year. Bonds rallied early in the year as oil prices collapsed and it became apparent the Federal Reserve was not going to raise interest rates at the pace they themselves had projected. The post-election stock rally negatively impacted bond prices as the Federal Reserve is now in play and increased economic growth may pave the way to higher rates.

If the economy begins to grow faster, expect interest rates to move higher in an orderly fashion. For the past two years the Fed told us they expected to raise the Fed Funds rate four times at 25 basis points in each year. Their eight forecasted rate hikes became one 25 basis move in 2015 and one in 2016. This will likely be the year when we finally get the four 25 basis point hikes. This is not all bad news, just reflective of a stronger economy where the Fed finally has room to maneuver.

Bond investors will need to prepare their portfolios and their expectations for a new world of gradually higher interest rates. Defense in bonds will be the name of the game. Short duration, floating rate notes, TIPS and asset-backed securities should provide the best opportunities in 2017. Own bonds to diversify your overall portfolio. Positive low-single digit returns would be the best outcome next year, and slightly negative returns would not be a surprise.

The New Year may see some consolidation from the post-election rally. If it comes, don’t be tricked into thinking it is the beginning of the end. Economic optimism and higher corporate profits fuel rallies. Our forecast is for 5-10% upside in equities next year with bonds struggling to produce positive returns. Stay positive, stay invested.

April 11, 2016

The stock market has rallied off the lows of January/February to stand slightly positive for the year. Part of the story has been the decline and subsequent recovery in oil prices during the first quarter. Oil prices and stock prices seem to be tied at the hip recently as illustrated in the chart below:

Oil prices seem to lead this correlation (oil up/market up and oil down/market down). Investors have been concerned that low oil prices would:

• Hurt overall earnings growth of the S&P 500
• Damage the high yield market if defaults rose in the energy sector
• Slow the global economy as energy production declined

These concerns appear to be valid. As oil prices have declined since mid-2014, the market has stalled since late-2014. Oils decline has been caused by an oversupply situation across the world. Oil crashed from more than $100 a barrel to a low of $27. Sentiment was especially grim earlier this year, but recently this has changed. Investors are beginning to sense the supply/demand imbalance is beginning to correct itself and oil prices (along with the market) have rallied.

Is oil demand increasing and supply actually falling? Let’s look at some recent data points to see.

On the demand side of the equation a consensus of energy analysts seems to feel that global demand will continue to grow. The IEA (International Energy Agency) expects higher demand in 2016 versus 2015. Researchers at Bernstein expect global oil demand to increase at a mean annual rate of 1.4% between 2016 and 2020, compared with annual growth of 1.1% over the past decade. They also “expect oil markets to rebalance by the end of 2016”. Bernstein adds that it forecasts global demand to reach 101.1 million bpd by 2020, from the current 94.6 million bpd.

More importantly, growth on the supply side of the equation seems to be abating, especially in the US. In reaction to substantially lower prices, domestic exploratory oil rigs have been taken off line, and production is falling. See the charts below:

In short, as rig counts (exploration) fall, production eventually falls. This process takes time, but eventually is positive for prices.

Finally, Guggenheim feels that global demand (purple line) will outstrip global supply later this year as non-OPEC production falls and world supply (blue line) flat lines. See the chart below illustrating this inflection point:

In conclusion, oil markets became over-supplied, but are self-adjusting through higher demand and lower supply. The adjustment process takes time, will be volatile, but is absolutely happening. If oil prices continue to recover over the next year, this should be a tailwind for the equity and high yield markets. The Gradient Energy Sector Portfolio was up close to 10% in the first quarter as its positions benefited from the recovery in oil prices. Further gains would be expected if oil finishes closer to $50 per barrel as we exit 2016, and $60 as we exit 2017.

March 23, 2016

Growth stocks out-performed the overall market for the two years ending December, 2015. During that time growth stocks rose more than 15% while the S&P 500 rose by nearly 12%. Value stocks during the same time rose just about 8%. But conditions have begun to change.

We all understand what growth means, but just what do we mean by value stocks? They are those with the lowest valuations based on price to earnings (P/E), price to sales (P/S) and price to book value (P/BV). Over longer periods of time, many stocks move, or rotate, from growth to value and sometimes back again.

The dynamics that caused under-performance for value stocks for nearly two years have changed over the last two months. We can see this in the chart below where the line represents the ratio of the S&P 500 growth and value indices:

Why have value stocks, particularly larger value stocks, under-performed for the last two years? We’ve had a few key headwinds:

· Growth in Europe and the emerging markets was slowing, affecting sales for large multi-national companies.
· The rising value of the US dollar challenged overseas sales and earnings growth for most US-based multi-nationals.
· Commodity prices, including oil, fell for three consecutive years which affected sales and profits for companies that rely on commodities for revenue.

In 2016 we have begun to see these headwinds turn into tailwinds:

· Oil prices have recovered from $27 per barrel, a 13-year low, to over $40 per barrel. We believe prices have likely bottomed and that the price will rise to the $50-60 range in 2016. What will drive the decline is falling non-OPEC production and increasing overseas demand, driving down inventories below expectations.
· Steady, low interest rates from the Federal Reserve since December are causing the US dollar to weaken to $1.12 per Euro from a low of $1.05 over the last four months.
· In commodities, plans are now in place to reduce supply, driving most commodity prices higher as global economic demand appears to be improving. We can see this in prices for most major commodities and also for shipping costs on a wide variety of commodities, which are recovering from a 30-year low.*

Apart from valuation metrics, we’ve seen those large cap, value stocks with their strong dividend yields gaining appeal as bond yields remain lower for longer. For instance, a market basket of large cap value stocks yield 2.8%** versus just 1.9% for 10-year US Treasury bonds.

Meanwhile, many fast growth, high valuation stocks winners of last year are faltering. For example, Amazon (AMZN) trades at 122 times forward estimated earnings per share, two times sales and 20 times book value. It pays no dividend. Year to date the stock price is down about 17%.

The Gradient 50 is an equally-weighted portfolio of 50 blue chip, dividend paying stocks that have these desirable low valuation characteristics. The G50’s total return (price plus dividend income) is out-performing the broad US stock market by over five percentage points year to date. We believe it is well positioned to outperform for the rest of 2016 since these companies tend to be:

· larger market capitalizations with exposure to higher growth in global markets
· paying dividends that yield 3.7% on average
· priced at lower P/E, P/S and P/BV valuations than the market average

Markets usually extend a trend longer than investors anticipate. For now Gradient Investments would prefer income and growth oriented investors allocate new equity dollars into the G50 portfolio. We continue to believe that market fundamentals will drive stock prices. These fundamentals are determined by the health of the overall economy and the profitability of the companies that operate within the economy.

*Source: “Baltic Index Slips Further, Hits New Record Low,” Reuters 2/10/2016

** Source: Vanguard VTV ETF fact sheet

February 26, 2016

Gold serves several purposes in a portfolio. For the last four years, there has not been much interest in the metal, but investors have been buying recently.

In fact, the price of gold is up 15% year to date, its best start to a year in 35 years as it outperformed stocks. See chart below* illustrating the performance of Gold (black line) versus the S&P 500 (blue line).

What’s driving the gains after years of under-performance? It’s the various roles that gold serves:

a) risk reducer in a volatile environment
b) protection against inflation
c) retention of purchasing power
d) protection against any possible decline in the U.S. dollar
e) a safe haven from “black swan” events

Let’s take a deeper look into each of these roles.

a) Gold is a non-correlated asset class, meaning that it doesn’t move in the same direction as the price of stocks or the price of bonds. The addition of gold can potentially reduce risk in a portfolio. In a volatile environment, as we saw in the Chinese stock market at the beginning of the year, it is actively sought out. We saw this in the sharp rise in money flows to precious metals funds in the first several weeks of this year as shown in the chart below.** Inflows haven’t been this strong since 2009.

b) Gold protects against inflation as it retains purchasing power by rising in value during inflationary times.

c) A handful of countries overseas are actually charging customers to keep their money in a bank these days, a complete reversal of traditional interest payments to depositors. Fear that this new practice will occur in the US as well is partly responsible for the recent gains in gold prices.

d) Gold protects against declines in local currencies. In fact, it often moves in the opposite direction of the US dollar. The US dollar has strengthened over the last two years versus most of the world’s currencies. If this reverses, we believe investors would benefit with a position in gold.

e) In the event of global upheaval, be it caused by terrorist attacks, war or any other unexpected geopolitical or financial shock, gold can be relied upon as a store of value. During these “black swan events”, gold prices rise as the metal becomes a go-to currency.

Currently gold is still less than 1% of global investors’ portfolios. It continues to be under-owned despite the recent price appreciation. With limited supply, this leaves the potential for further price appreciation. You could buy gold bars, metal coins, stocks or mutual funds holding gold miners. Exchange traded funds (ETFs) provide flexibility since they are priced daily, are highly liquid and track the price of gold accurately.

At Gradient Investments, we currently include a gold ETF in our Endowment Series. Gradient’s Precious Metals portfolio is our most direct method to benefit from higher precious metals prices. The portfolio includes positions in gold along with silver, platinum and palladium. In addition, precious metal mining company stocks are included.

In summary, precious metal investing can be volatile, but a reasonable allocation to this asset class over time can be beneficial.

Sources:

* Yahoo Finance interactive charts ** Bank of America Merrill Lynch, EPFR Global

February 15, 2016

Investors around the world are concerned these days about the stock markets and their respective economies. The laundry list of concerns is lengthy and includes:

• Global economic slowdowns, especially in manufacturing
• Looming recession in the US and other countries
• Bond market, and more specifically high yield, credit deterioration
• Federal Reserve interest rate policy direction
• Low oil prices and the threat of deflation
• The Chinese stock market crash
• Concerns over the big European banks
• And finally, 4th quarter 2015 earnings that were at best in line with expectations

This list of concerns is long and has challenged the fortitude of investors. In 2016 both selling and volatility has increased. Because of this the financial news networks are of course fanning the flames of anxiety among investors.

• In my opinion the general fundamentals of both global economies and investment markets have somewhat deteriorated
• It is also my opinion that global stock markets have “already reflected” these concerns

Look at the chart below reflecting the declines of global stock markets the past 9 months:

And below is a table of global indices illustrating YTD 2016 performance as of February 12th:

We see that global stock markets have been declining since May of 2015, and the decline has accelerated in 2016. Collectively, markets are down roughly 20% across the globe from their peaks.

The big question is where do we go from here? Are the weakened fundamentals pointing towards a global recession? Will the markets continue to cascade further? We don’t think so, in fact we believe the US economy is experiencing a slowdown, not a recession, caused by declining oil prices, a strong dollar, weaker international economies and a pause in the growth of corporate profits. We also think this slowdown is more than adequately reflected in lower stock prices.

Going forward we’re encouraged by recent data that point to continued expansion of the US economy. They include:

• Continued housing market strength
• An acceleration in consumer spending
• A decline in the unemployment rate
• An acceleration in wage inflation
• An increase in consumer confidence
• Bank lending at its strongest levels since the financial crisis

In addition, equity market valuations are much more reasonable, U.S. corporate earnings are forecast to grow again in 2016, global banking system capital measures are strong and oil just had its biggest one day rally since 20009.

The bears have had their way recently. Yes, everything is not perfect in the global economy and their investment markets, but there never is a perfect environment. As the slowdown fades and global growth resumes I believe markets are oversold and due for a rally.

February 1, 2016

The market sold off in the first few weeks of January, spooked by the new year’s hit to the normally volatile Chinese stock market and compounded by anxiety over the quarterly earnings reports and outlooks. Early in the month fears affected nearly every sector: technology, energy, financials, industrial, and health care. During the first three weeks, the S&P sold off 7%, for the worst start to the new year on record.

In all the nervousness, first quarter 2016 earnings estimates for the S&P 500 were reduced by nearly 5%, to $27.76 from $29.14 per share.* Now with 40% of the companies in the S&P having already reported last quarter’s earnings:

• over 70% reported better than estimated earnings
• nearly 10% reported in line with expectations.

While it’s still early in the year, we expect to see estimates increase again in the coming weeks and months.

Meanwhile the Chinese economy continues to grow at a rate of nearly 7%.** This growth has been in a gradual decline and reflects a change in government direction from an industrial-oriented economy toward a consumer service-driven economy. This is a slowdown from over the 9% growth rate of a few years ago. However, the growth rate reported in January for the prior quarter was still within most economists’ expected range, and does not warrant additional concerns at this juncture. As we’ve pointed out in the past, China represents just 2% of our total exports.

Given the market correction both here and abroad, however, it certainly presents many opportunities. Specifically, we believe the stocks of large cap, multinational companies with strong balance sheets that offer good dividend yields and have the capacity to continue to grow dividends at a rate faster than inflation have been hard hit in January and offer tremendous value currently. These are the types of stocks that we own in the Gradient 50 portfolio.

Looking at US stock valuations, they were pushed down from 16.1 times forward twelve months earnings at the end of December to just 15.2 times currently. This compares to 17.2 times last February. See the chart below.

We believe this new, lower valuation is very attractive for new money coming into the market, particularly given modest estimates for earnings growth of just 5% in 2016.

Annual earnings growth is just one metric. The pace or cadence of growth is also important, that is, whether earnings growth is accelerating or decelerating. We believe it’s accelerating. Look at the consensus outlook for earnings growth in the next several quarters as provided by FactSet in the chart below.

Earnings estimates for the coming year reflect a widespread view that the headwinds to earnings growth in 2015 (namely falling oil prices and the strength in the US dollar) will fade and become tailwinds to growth in 2016. With our outlook for an accelerating rate of growth in the coming quarters, we believe current valuations have overly discounted this scenario.

Companies in the Gradient 50 portfolio, with their exposure to international sales and energy, should benefit from these tailwinds. With large capitalization stock prices down 6% on average for the month of January, we believe now is an opportune time to add to your holdings for dividend income and potential capital gains.

Sources: * FactSet 1/29/2016
** Reuters 1/19/2016