Author: Franklin J. Parker

by Franklin J. Parker

The Summary

• Last week’s event was Fed Chair Powell’s testimony before congress. Again the central bank reiterated that the economy is still “a way off” from reaching its goal of “substantial further progress.” Of course, the chairman himself said that is difficult to be precise on the meaning of “substantial further progress.” This, all while the Fed’s board has grown less dovish, with their own projections for rate hikes moving closer and faster than previously anticipated (this projection is known as the “dot plot”). Investors should price to the board’s dot plot rather than the chairman’s verbal guidance, in my view.
  
  
• Earnings season began last week with several major banks reporting earnings. Earnings were much better than expected, but much of that boost came from capital markets business—underwriting IPOs, mergers & acquisitions, etc. Traditional banking is struggling amid low interest rates and limited lending volume, so this good news is still not as good as it could be. More earnings this week, with IBM, NFLX, INTC, KO, and TWTR reporting.
  
  
• Growth worries seem to be gripping stocks. There is worry that the Fed will begin withdrawing support from markets and that the rosy growth projections may have been slightly overdone. In addition, the Delta variant of Covid is gaining momentum and showing signs that it can punch through the vaccines (though vaccinated people appear to have much milder cases than unvaccinated people). Even without government-imposed lockdowns and travel restrictions, fear of the Delta variant may be push enough people to slow their travel and pull back from going out to restaurants and shops. Just the fear, then, could dent economic growth in coming quarters.
  
  
• My view is that we should not be too worried just yet, but this is worth watching very closely. We should be prepared to react quickly should things shift against us in a meaningful way. Remember, the Fed is still in play, and they will be very reluctant to give back hard-won economic ground—signs of weakness in the real economy could push the Fed to change guidance and/or increase their support. Counterintuitively, a surge in Covid cases leading to weakness in employment may well result in higher market prices.
  
  

The Details

What is a bubble, exactly?

This may be a silly question to ask, I admit. Everyone knows what a bubble is, right? Yet in my experience, other than someone simply declaring “that’s a bubble,” I have yet to find firm definition of what actually makes a bubble. That is an important point in my mind because simply declaring “that’s a bubble” (1) does not help us understand how the bubble formed and what may cause it to pop, nor (2) does it make me at all confident that this person is correct! I am a “show me your work” kind of guy. I’m not one to accept someone’s declaration as fact.

What’s more, there is a whole line of economic thought that denies the concept of “a bubble” even exists! Nobel-laureate Eugene Fama famously said, “I don’t even know what a bubble means. These words have become popular. I don’t think they have any meaning.” To be fair to Fama, his point is that the concept is only useful if it helps to make good predictions and you can profit from it. He does not believe the evidence shows that it is useful for either.

There are some loose frameworks for thinking about bubbles. Of all the bubble theories with which I am familiar a geophysicist, Didier Sornette, applied some earthquake theory to financial markets with reasonable success. Sornette’s bubble theory has the advantage of explicit predictions—he claims to be able to forecast when bubbles will pop to within a few days! (For those less quantitatively inclined, his institute for financial risk at ETH Zurich posts a monthly bubble report that I myself review every month).

Despite its history and obvious utility, I remain skeptical of Sornette’s bubble theory. Just like any other tool in financial markets, there are times it seems to work and times it doesn’t. It is, I think, best used in a mix of tools.

And therein lies my trouble. There is no “mix of tools” when it comes to bubbles.

So, here is my loose framework for thinking about bubbles. There is an important quantitative component which I won’t bore you with here, but an understanding of just the framework is helpful I think.

I think our intuition of bubbles is pretty simple, and can help us with a working definition: something is a bubble when it is fragile with respect to some input. So, for example, through 2001 to 2007, housing prices became fragile with respect to poor underwriting and the proliferation of derivatives. Admittedly, these were obscure inputs to spot, but some financial professionals did spot that fragility and bet on it breaking well in advance of the broader marketplace.

What I like about this definition is that it is about something other than price. Prices going up may or may not be the sign of a bubble. Even if price increases are a symptom of a bubble, that does not help us understand how/why/when the bubble might pop (and prices go down). By focusing on the inputs, we can focus on the underlying problem rather than the symptoms.

This definition also helps us find the source of fragility. Doing a cursory analysis on housing prices in 2006/2007 would not have yielded a satisfying answer—it wasn’t really interest rates or housing supply that was driving the boom, and that should push a dedicated analyst to dig deeper. Once the problem of underwriting and derivatives were found, the source of fragility would be clearer and the analyst could watch those signals for signs of weakness, and thus be prepared for the popping of the bubble.

Financial markets today are quite fragile with respect to economic policy—and have been for the past decade. Markets are generally hooked on the federal reserve and ever-lowering interest rates. This has driven prices across all asset classes ever higher, and created a systemic problem. When the bubble pops, everything pops together.

This means that investors should watch these sources of fragility very, very closely. And remember, prices can stay absurd for a very, very long time. Japan is a good example. They have been running this economic experiment for about 30 years, and it is still going. Most investors simply cannot sit on the sidelines for their entire professional life waiting for a bubble to pop. Thus, understanding the source of the bubble can also give nervous investors confidence to step into financial markets, with an understanding that backing away may be appropriate if the system begins to crack.

As always, this is something we would be delighted to chat about with you.

Chart of the Week

This week’s chart is a simple reminder (to myself as much as anyone else). Stock markets do not go straight up! In fact, it is rare for markets to hit new highs for multiple days in a row. Normally, stocks tend to hit an all-time high, pull back 2% to 5%, then move again to an all-time high. A 2% to 5% pullback happens about once every month, so it is itself little cause for concern. Over the past six months, we even saw a 6% pullback in February-March.

The point is, periodic weakness in markets is pretty normal, and we cannot use that weakness alone as a measure of our next actions. More than anything, we have to keep an eye on the drivers of market fundamentals, even more than actual market prices.

This document is a general communication being provided for informational purposes only. It is educational in nature and not designed to be taken as advice or a recommendation for any specific investment product, strategy, plan feature or other purpose in any jurisdiction, nor is it a commitment from Directional Advisors to participate in any of the transactions mentioned herein. Any examples used are generic, hypothetical and for illustration purposes only. This material does not contain sufficient information to support an investment decision and it should not be relied upon by you in evaluating the merits of investing in any securities or products. In addition, users should make an independent assessment of the legal, regulatory, tax, credit, and accounting implications and determine, together with their own financial professionals, if any investment mentioned herein is believed to be appropriate to their personal goals. Investors should ensure that they obtain all available relevant information before making any investment. Any forecasts, figures, opinions or investment techniques and strategies set out are for information purposes only, based on certain assumptions and current market conditions and are subject to change without prior notice. All information presented herein is considered to be accurate at the time of production, but no warranty of accuracy is given and no liability in respect of any error or omission is accepted. It should be noted that investment involves risks, the value of investments and the income from them may fluctuate in accordance with market conditions and taxation agreements and investors may not get back the full amount invested. Both past performance and yields are not reliable indicators of current and future results.

by Franklin J. Parker, CFA

The Summary

• Earnings season kicks off this week. Investors will be watching the figures and listening to forward guidance very closely. There are mixed signals on the recovery, and earnings season stands to offer some clarity on the ongoing economic recovery. The big banks start this week, including JPMorganChase, Bank of America, Goldman Sachs, and Wells Fargo. Alcoa, long considered a bellwether for manufacturing, also reports earnings this week. I am listening carefully for CEO commentary on inflation and the rising costs of their manufacturing inputs (like labor and materials).
  
  
• In addition to earnings, we get inflation data on Tuesday, producer prices on Wednesday (another inflation measure) along with The Fed’s Beige Book on Wednesday (the Fed’s assessment of the economy), industrial production figures on Thursday, and retail sales on Friday. Oh yes, and Fed Chair Powell testifies in front of Congress on Wednesday/Thursday. All-in, this could be a very important week for data!
  
  
• Last week was fairly quiet on data and financial news. The European Central Bank announced a shift in their inflation targeting policy. Similar to the change made by the US Federal Reserve a few years ago, the ECB will now target an average inflation figure, rather than a red-line inflation figure. ECB President Christine Legarde announced today that investors should expect updated policy guidance this week—almost certainly meaning ongoing/increased quantitative easing and low interest rates.
  
  

The Details

Stagflation is back?

Stagflation is an environment in which the economy is stagnant, but inflation is high. This tends to yield lower stock prices, high unemployment, and rising prices—a bad combination! These moments are rare in economic history, but the late 1970s to early 1980s are a vivid reminder of how bad things can be, and—at least up until now—the Federal Reserve has been keen to avoid even a whiff of catalyzing such an environment.

So far in this recovery, however, inflation and economic growth have been in keeping with their expected trends, however, with inflation posting considerably hotter than expected over the past few months and economic growth normalizing, investors have begun talking about a possible stagflation scenario. Admittedly, these are tough environments to navigate, and most of the veterans who managed money through the Volker years have long since retired. In other words, there is little institutional memory of the nuance to managing through such an environment. The worry is legitimate.

I am not yet convinced that stagflation is on the horizon. My current thesis is that we are going to be stuck in a long-term low growth/low inflation environment for the foreseeable future (not unlike Japan). Of course, my view will change as the data changes. That said, it is my job to think through possible investment scenarios and have contingencies for them. I never want to be scrambling to think through a strategy for an unforeseen economic environment.

Generally speaking, the stagflation investment plan goes something like this:

• Avoid long-dated US Treasury bonds. With inflation expectations changing often and quickly, investors will reprice US Treasuries constantly. This creates lots of volatility in the space. Furthermore, because equity investors are doing the same, bonds cease to offset stock losses. The same tends to be true for corporate bonds. Staying duration neutral is the best strategy in a stagflationary scenario. That insulates your portfolio from the volatility of interest rates while markets reprice inflation expectations.
  
• Stocks, generally, tend to perform poorly. With high unemployment, low wage growth, and higher costs, companies have difficulty producing profits in a stagflation environment. Of course, there are always some companies that perform well. Finding those companies and sectors that generate growth and continue higher is critical (I looked at the interest-rate sensitivity of various sectors to interest rate changes in a previous post).
  
• Commodities generally outperform. Tilting an investment portfolio to be overweight commodities (or commodity producers) may be a helpful way to gain growth exposure. That comes with a cost, of course, as commodities are considerably more volatile than stocks.
  
• Depending on the global picture, picking up higher international exposure may be worthwhile. Inflation is, at heart, a rapidly depreciating currency. So, by moving your cash into a foreign currency, you can make money as your home currency loses value. In essence, you buy a foreign investment with dollars that are more valuable today, then you sell the foreign investment and use the foreign currency to buy even more dollars in the future (because the foreign currency gained value relative to the dollar).

The point is, there is a way to approach any economic environment. And, while I do not yet see stagflation on the horizon, there is a playbook for it.

Chart of the Week

FactSet reports that the S&P 500 is expected to report year-over-year earnings growth of 64%—the largest growth in over 10 years. This week’s chart is from FactSet, and shows their bottom-up target price vs closing price for various sectors. In other words, this is how undervalued/overvalued, they see current sectors.

Energy is clearly favored, followed by materials and communication services. This should be little surprise as energy was decimated by the Covid recession, and materials have benefitted from both the recovery and the recent bout of inflation. Real Estate is most fairly valued, and this is again little surprise.

Of most surprise to me is their assessment of technology—expected by FactSet to underperform the S&P 500 as a whole. After powering through the recession with relative ease, and leading the recovery, investor views have shifted on technology. Of course, that isn’t to say that individual companies won’t outperform, but that the sector as a whole may be out of favor.

This document is a general communication being provided for informational purposes only. It is educational in nature and not designed to be taken as advice or a recommendation for any specific investment product, strategy, plan feature or other purpose in any jurisdiction, nor is it a commitment from Directional Advisors to participate in any of the transactions mentioned herein. Any examples used are generic, hypothetical and for illustration purposes only. This material does not contain sufficient information to support an investment decision and it should not be relied upon by you in evaluating the merits of investing in any securities or products. In addition, users should make an independent assessment of the legal, regulatory, tax, credit, and accounting implications and determine, together with their own financial professionals, if any investment mentioned herein is believed to be appropriate to their personal goals. Investors should ensure that they obtain all available relevant information before making any investment. Any forecasts, figures, opinions or investment techniques and strategies set out are for information purposes only, based on certain assumptions and current market conditions and are subject to change without prior notice. All information presented herein is considered to be accurate at the time of production, but no warranty of accuracy is given and no liability in respect of any error or omission is accepted. It should be noted that investment involves risks, the value of investments and the income from them may fluctuate in accordance with market conditions and taxation agreements and investors may not get back the full amount invested. Both past performance and yields are not reliable indicators of current and future results.

by Franklin J. Parker, CFA

The Summary

• The big news last week was the Fed’s announcement that they are now talking about tapering (tapering = a slowdown and end to their ongoing $120 billion/month money printing). Powell has been very clear that they would give plenty of notice in advance of ending the program, and it would not end overnight—there would be some glidepath by which they slow down and eventually end. The next meeting would be the earliest time they could give a schedule, but it seems that most economists expect a schedule at the September meeting. If history is any guide, it could well be a year or more before the money-printing ends, another few years where the existing money supply is maintained, and years before the Fed begins shrinking the money supply. There is a ways to go.
  
  
• Markets jumped around in response to the Fed’s announcement last week, but more in response to the updated “dot plot.” The dot plot is the individual FOMC member’s expectation for interest rates in the coming years. Bottom line: more Fed members expect interest rates to begin rising in 2023, rather than 2024, which also means they must expect tapering to happen faster than previously expected. While stocks moved around (though not much—at most, the S&P 500 was off about 2% from its recent high), of most note was how the 10-year US Treasury jumped to 1.59%, then settled back below 1.5%. Right now, it stands at 1.44%. This signals that (1) investors are now less concerned about inflation, and (2) investors may be a bit pessimistic at future economic growth, given the Fed’s adjusted stance.
  
  
• Data on durable goods orders post this week for April, we get final figures on core PCE, and the usual initial jobless claims data (380,000 expected claims for last week). None of this is expected to push markets around, but with the Fed taking a more hawkish tone, bad news may become bad news again. That said, while I acknowledge some market risks in the short term, I actually think there is some upside surprise to be had here. The Fed is still printing money for the rest of this year, and GDP growth is expected to be in the high 6% for the year. In other words, we have both the support of the Fed and stellar economic growth for the remainder of 2021—I tend to think that sentiment will improve as corporate earnings begin to post in July, though I could see some market weakness in the interim.
  
  

The Details & Charts of the Week

Interest rates have been a constant news item for, well, years. Along with that conversation is the inevitable discussion of their affect on equities. All else equal, it is true that higher interest rates should lower equity valuations (P/E ratios, or how many dollars an investor is willing to pay for $1 in corporate earnings). That said, it is not always true that higher interest rates yield lower equity prices.

At any rate, I have spent some time looking at both the theoretical change in equity valuations, and, most recently, some time looking at how equity prices move in relation to interest rate moves. In this week’s discussion, I thought we should look at the latter.

Our first look it the obvious one: how do large cap US company prices move with interest rates. Looking at the quarter-over-quarter difference in the 10-year US Treasury yield and the change in S&P 500 prices since 1990, we see that there tends to be a positive relationship: as interest rates move higher, so do S&P 500 prices.

What should be immediately clear is that, while there is a slight positive correlation, we cannot infer that higher rates cause prices to move higher. Indeed, the math would suggest the opposite should be true. It is therefore much more likely that they are both influenced by the same third force: economic growth. As the economy begins to grow, both rates and stock prices tend to move higher, and the inverse is also true.

The good news here is that economic growth often overwhelms the negative force of higher rates in stock prices.

Of course, time period matters. While the chart above is for the 30-year period spanning 1990 to today, the chart below is the 30-year period from 1960 through 1989. As you can see, the relationship, while much looser, was negative. As interest rates went up, equity prices tended to go down. 1960 to 1990 was a period characterized by intense inflation and generally stagnant economic growth, and this could very well be a third and fourth force acting on both interest rates and stock prices, creating an opposite relationship to the one from 1990 to today.

Small cap value stocks have a similar relationship with interest rates, though the correlation is a bit stronger. As rates move higher, so do prices. Again, I take this as a signal that economic growth is a more important factor than higher interest rates, though interest rates do seem to exert some influence.

A sector-by-sector breakdown yields varying degrees of the same effects, with a few exceptions. Rather than walk through each relationships, let’s look at a couple of exceptions.

Since 1990, there has been a loose negative relationship between price changes in the Utilities sector and changes in interest rates. This makes some sense as utilities are a defensive sector, and they also tend to be heavily indebted. When the economy slows down and interest rates fall, Utilities may not fall as often as the broader market because investors sell other sectors to buy Utilities (although Utilities have had some rough quarters when interest rates have fallen!). Also, as interest rates move higher, the cost to service their debts goes up. These two effects could be why this relationship is both negative and weak.

Also of note is the behavior of the Real Estate sector. Real Estate, interestingly, tends to react less to the direction of rates and more to the extremity of the move. As rates move significantly—either up or down—we tend to see a negative reaction in publicly-traded real estate prices. We see this in the chart below—positive price changes cluster around no changes in rates, while negative moves tend to cluster at the left and right of the chart.

Here are my take-aways from this look at interest rates and equity prices:

• Many factors are at work on prices at any given time. Investors must evaluate each effect within the context of others. The aggregate net effect is what we must concern ourselves with.
  
• Economic growth can easily overcome the negative effects of interest rate moves, which is good news.
  
• Not all sectors respond the same to interest rate moves.

In the end, investors should be concerned with interest rates and their effects on stock prices, but it should not be the only consideration. It is also not true to say that higher interest rates are absolutely bad for stock prices—it very often depends on why rates move higher. As always, risk control and a firm understanding of the factors working on your investment portfolio are key.

In this context, it is my view that 2021 is likely to be a good year for equities. The Fed is very likely to continue printing money for the remainder of the year, and economic growth—the most critical factor for equity investors—is projected to be very strong.

Not to mention, rates seem unable to move meaningfully higher, anyway.

This document is a general communication being provided for informational purposes only. It is educational in nature and not designed to be taken as advice or a recommendation for any specific investment product, strategy, plan feature or other purpose in any jurisdiction, nor is it a commitment from Directional Advisors to participate in any of the transactions mentioned herein. Any examples used are generic, hypothetical and for illustration purposes only. This material does not contain sufficient information to support an investment decision and it should not be relied upon by you in evaluating the merits of investing in any securities or products. In addition, users should make an independent assessment of the legal, regulatory, tax, credit, and accounting implications and determine, together with their own financial professionals, if any investment mentioned herein is believed to be appropriate to their personal goals. Investors should ensure that they obtain all available relevant information before making any investment. Any forecasts, figures, opinions or investment techniques and strategies set out are for information purposes only, based on certain assumptions and current market conditions and are subject to change without prior notice. All information presented herein is considered to be accurate at the time of production, but no warranty of accuracy is given and no liability in respect of any error or omission is accepted. It should be noted that investment involves risks, the value of investments and the income from them may fluctuate in accordance with market conditions and taxation agreements and investors may not get back the full amount invested. Both past performance and yields are not reliable indicators of current and future results.

by Franklin J. Parker, CFA

The Summary

• Last week’s big news was the surprisingly high inflation print for May. Markets had largely expected higher inflation, predicting a 4.7% year-over-year increase in prices. However, headline inflation posted at a startling 5%. The Fed, of course, has repeatedly said that they expect inflation to run hotter than normal due to both base effects (comparisons to last year’s drop in prices means the increase looks larger than it actually is) and temporary supply chain problems brought on by the pandemic.
  
  
• Speaking of the Fed, this week is the monthly FOMC meeting. Given the ongoing improvement in the labor market and the recent inflation surprise, the committee is fully expected to start “talking about talking about tapering.” In English, this means they are expected to at minimum mull a timeline for the slowing of money-printing, and at maximum offer a specific timeline for the end of that policy. I estimate that markets have priced-in a Q4 begin to tapering. Wednesday’s press conference may well move markets if that expectation is shifted.
  
  
• In addition to Fed commentary, we get data on producer prices (another inflation measure), retail sales, and industrial production—all on Tuesday. These are important data points to watch as they will give a strong indication at the health of the ongoing economic recovery. As the Fed begins to remove its support, economic growth will become ever-more important to investors.
  
  

Charts of the Week / The Details

Rather than dive deeper into one topic, this week I’d like to parooze several data points regarding the US economic recovery. As mentioned in The Summary, I expect the economic recovery to become an ever-more important data point as the Fed backs away.

Since all of this economic trouble was pandemic-induced, a look at how the US is progressing toward eliminating the pandemic is a good start in estimating how quickly economic life returns entirely to normal. As it stands, a little over 50% of the 16+ population has been vaccinated. Given that in January of this year, about 0% of the population was vaccinated, I would say that this is pretty good progress. However, if we look at the total number of the population who have both had Covid or have been vaccinated, we can see that the data is more encouraging. Over 60% of the adult population has either had Covid and/or received full vaccinations, which is not that far from the 70% needed for herd immunity. Some of that is overlap of course (some people have had both Covid and Vaccines), and kids are not included in these stats, but this is nonetheless an encouraging step toward getting economic growth back on track!

Looking at the breakdown of job losses and gains during and after Covid shows that Leisure and Hospitality took a pretty big hit. Total employees in the industry dropped from about 17 million in January of 2020 to about 9 million—an almost halving of total employees! While the recovery has begun, there are still 3 million or so employees who need to be rehired just to get back to January 2020 levels—not to mention the extra employees needed to simply recover the growth that would normally occur over the course of 18 months. There are several sectors where this is so, though few (if any) as dramatic as Leisure and Hospitality.

Job openings have risen to a record high. This is a good sign for workers, but there is a mystery here, as well. While job openings are at an all-time high, the unemployment rate remains in the high 5%-range. In other words, the improvement is not as quick as one might expect given this level of bounce in job openings. In that vein, there are several competing data points in the labor market, some which show dramatic improvement, and some which show considerable ground yet to cover to be fully recovered.

Another way to gain some sense of economic confidence is to look at the percentage of small businesses planning capital expenditures in the next 3 to 6 months. After cratering in 2020, small businesses appear to have regained some confidence, with around 27% of businesses reporting their intent to spend money on capital improvements.

In the end, there is quite a lot of good news out there. The economy is still recovering, to be sure, but it does appear that it can stand on its own. As I’ve written about before, a too-quick withdrawal of support would be a definite negative to markets. However, if the Fed manages to get the balance right, investors may not need to worry too much about whether the economy sustain its own growth.

This document is a general communication being provided for informational purposes only. It is educational in nature and not designed to be taken as advice or a recommendation for any specific investment product, strategy, plan feature or other purpose in any jurisdiction, nor is it a commitment from Directional Advisors to participate in any of the transactions mentioned herein. Any examples used are generic, hypothetical and for illustration purposes only. This material does not contain sufficient information to support an investment decision and it should not be relied upon by you in evaluating the merits of investing in any securities or products. In addition, users should make an independent assessment of the legal, regulatory, tax, credit, and accounting implications and determine, together with their own financial professionals, if any investment mentioned herein is believed to be appropriate to their personal goals. Investors should ensure that they obtain all available relevant information before making any investment. Any forecasts, figures, opinions or investment techniques and strategies set out are for information purposes only, based on certain assumptions and current market conditions and are subject to change without prior notice. All information presented herein is considered to be accurate at the time of production, but no warranty of accuracy is given and no liability in respect of any error or omission is accepted. It should be noted that investment involves risks, the value of investments and the income from them may fluctuate in accordance with market conditions and taxation agreements and investors may not get back the full amount invested. Both past performance and yields are not reliable indicators of current and future results.

by Franklin J. Parker, CFA

The Summary

• Last week’s labor market news was mixed. On the one hand, the US economy added only 559,000 jobs in May—over 100,000 less than expected. However, initial unemployment claims fell to below 400,000 for the first time since the pandemic began, which is a good sign. I think the take-away for investors is that there is LOTS of recovery to go before the economy is back to its pre-Covid levels, especially in the services sector.
  
  
• The big news last week was the Fed’s newly-adopted hawkish tone. At his press conference less than 30 days ago, Fed Chairman Powell reiterated that it was not even time to begin talking about talking about tapering (“tapering” = slowing down the creation of money to buy assets). Last week, San Francisco Fed President Daly acknowledged that “we are talking about talking about tapering.” The news was fairly well received by markets, which have been spooked by inflation. As I mentioned before a hawkish Fed doesn’t necessarily mean asset prices drop, other forces matter, too. Ideally the Fed can exit current policies with minimal asset-price damage, but it will be a tightrope to walk.
  
  
• Last week’s beginning-of-the-month data deluge means this week is considerably lighter in terms of new data. However, we do get the official inflation print on Thursday which could easily be market-moving. We also get weekly initial unemployment claims on Thursday.
  

The Details

Some big music deals have been in the news lately. Last week it was announced that Joel Little—songwriter for Taylor Swift, DJ Khalid, and Lorde—has sold his catalogue to Hipgnosis Song Fund. This, after last year’s mega-deal for Bob Dylan’s song catalogue, which sold for an unknown amount (but which was “in the 100s of millions”).

In a world with little-to-no yield, investors have had to get creative in their search for return on investment. The business of music royalties has changed in an era of subscription music streaming services, and music royalties offer investors a stream of cashflows that is different from the more traditional bond structure. Music royalties tend to decay—that is, an artist’s music tends to have a shelf-life as people move on to new artists—but there are industry metrics to help investors adjust valuations for this fact.

Ironically, however, though music royalties may start as an asset class that is unrelated to more traditional risks, they are likely to become ever-more subject to these risks (like interest rate moves, or credit quality) as the asset class becomes “financialized.” Investors face opportunity costs, after all, and if a high-quality bond yields more than a music portfolio, investors will sell down their music portfolio to buy the bond. This forces prices in the music portfolio to move in response to the rest of the financial market.

My point is this. Though our current financial market is replete with innumerable different types of investments—and more are created every day—there are, in the end, only a handful of factors driving portfolio risk. It is those risk factors which drive return, and your decision as to which investments you use to gain risk exposure is secondary to getting the balance of risk factors correct.

Diversification is more complicated than just picking lots of investments!

Chart of the Week

Though mostly a holdout from a bygone era, the Taylor rule has long been considered the theoretical target for the Federal Reserve’s interest rate policy. In general, the Fed’s funds rate more-or-less follows the Taylor rule, though often the Fed will ignore it for a while. With the economic recovery picking up steam and inflation beginning to heat up (at least for now), the theoretical target rate is beginning to tick up. The Fed will likely ignore this move for now, but as the differential between the “should-be” rate and the actual rate increases, so too will pressure on the Fed to push interest rates higher.

This document is a general communication being provided for informational purposes only. It is educational in nature and not designed to be taken as advice or a recommendation for any specific investment product, strategy, plan feature or other purpose in any jurisdiction, nor is it a commitment from Directional Advisors to participate in any of the transactions mentioned herein. Any examples used are generic, hypothetical and for illustration purposes only. This material does not contain sufficient information to support an investment decision and it should not be relied upon by you in evaluating the merits of investing in any securities or products. In addition, users should make an independent assessment of the legal, regulatory, tax, credit, and accounting implications and determine, together with their own financial professionals, if any investment mentioned herein is believed to be appropriate to their personal goals. Investors should ensure that they obtain all available relevant information before making any investment. Any forecasts, figures, opinions or investment techniques and strategies set out are for information purposes only, based on certain assumptions and current market conditions and are subject to change without prior notice. All information presented herein is considered to be accurate at the time of production, but no warranty of accuracy is given and no liability in respect of any error or omission is accepted. It should be noted that investment involves risks, the value of investments and the income from them may fluctuate in accordance with market conditions and taxation agreements and investors may not get back the full amount invested. Both past performance and yields are not reliable indicators of current and future results.

by Franklin J. Parker

The Summary

• The fundamental economic data was pretty mixed last week. Personal incomes for April dropped unexpectedly after the majority of stimulus payments were distributed in March. We saw personal spending decline, as well. Core PCE (personal consumption expenditure—the Fed’s preferred measure of inflation) jumped more than expected, and it was the highest 12-month jump in the metric since 1992. Again, price comparisons to last year are fraught since prices had declined so significantly, so much of the jump can be attributed to simple normalization. Initial unemployment claims dropped to the lowest level since the Covid-induced recession began. 406,000 people filed for initial unemployment claims. While this is still very high on a weekly basis, it is much more normal! Initial claims under the 225,000/week mark would be consistent with an expansionary economy.
  
  
• Kurt Campbell, Biden’s National Security Council coordinator of Indio-Asian Affairs, made news last week with his quote, “The period that was broadly described as engagement has come to an end…the dominant paradigm is going to be competition.” Slowing and reversing the trends of globalization—especially with regard to China—appears to now be a bipartisan consensus. As I wrote last week, this reversal will likely lead to upward price pressure on consumer goods over the longer-term.
  
  
• We get another read on the health of the labor market this Friday with the posting of the headline unemployment rate. Factory orders also post this Friday. The consensus is a slight downtick in the unemployment rate, and a slight contraction in factory orders. Considerably better data may push markets around, as belief that the Fed will keep current policy going is fading.

The Details

Well, it is time.

The Fed has decided it is time to start talking about talking about tapering (“tapering” is just Fed-speak for “slowing down our money-printing”). At April’s press conference, Chairman Powell was asked whether it was “time to start talking about talking about tapering,” to which he responded “no it’s not time yet. We’ve said we’d let the public know when it is time to have that conversation, and we’ve said we’ll do it well in advance of any decision to taper our asset purchases, and we will do so.”

With inflation posting hotter than expected, two Fed vice chairmen both declared last week that the Fed would begin to talk about slowing the Fed’s pace of money-printing. Given that both vice chairmen are on Powell’s leadership team, their comments carry quite a bit of weight. It is now widely expected that the Fed will discuss an end to their ongoing quantitative easing program (“quantitative easing” is just Fed-speak for “money-printing”).

Of course, an end to quantitative easing (QE) is likely to create a headwind for markets. According to my back-of-the-envelope calculations, an end to QE makes market growth about 4.5% less than it otherwise would be. Earnings growth is still the largest single factor in market returns, so these forces must be weighed by investors—there is not a clear course of action.

As I have said before, mental flexibility and agility may be our best weapons in this unknown economic climate.

Chart of the Week

The Euro area is still reeling from the Covid recession. All but two countries are still seeing significant economic contractions, even in Q1 of 2021. For the first time in a while, investors may be well served by increasing allocations to developed economies in Europe, especially if we expect their growth to turn a corner with increasing vaccination rates.

A major challenge to overseas investing, however, is the currency exchange rate. Dollars must be converted to Euros to buy shares of European companies. If the Euro weakens relative to the dollar, US-based investors can lose money on an otherwise profitable investment. The point is, there may be opportunity, but it must be carefully evaluated.

This document is a general communication being provided for informational purposes only. It is educational in nature and not designed to be taken as advice or a recommendation for any specific investment product, strategy, plan feature or other purpose in any jurisdiction, nor is it a commitment from Directional Advisors to participate in any of the transactions mentioned herein. Any examples used are generic, hypothetical and for illustration purposes only. This material does not contain sufficient information to support an investment decision and it should not be relied upon by you in evaluating the merits of investing in any securities or products. In addition, users should make an independent assessment of the legal, regulatory, tax, credit, and accounting implications and determine, together with their own financial professionals, if any investment mentioned herein is believed to be appropriate to their personal goals. Investors should ensure that they obtain all available relevant information before making any investment. Any forecasts, figures, opinions or investment techniques and strategies set out are for information purposes only, based on certain assumptions and current market conditions and are subject to change without prior notice. All information presented herein is considered to be accurate at the time of production, but no warranty of accuracy is given and no liability in respect of any error or omission is accepted. It should be noted that investment involves risks, the value of investments and the income from them may fluctuate in accordance with market conditions and taxation agreements and investors may not get back the full amount invested. Both past performance and yields are not reliable indicators of current and future results.

by Franklin J. Parker, CFA

The Summary

• The Federal Open Market Committee’s minutes were posted last week, and markets were a bit surprised at the hawkishness of several members (“hawkishness” = concern about inflation). Several FOMC members said that “it might be appropriate at some point in upcoming meetings to begin discussing a plan for adjusting the pace of asset purchases” given the recent progress in the economic recovery. This made investors wonder whether the current program of money-printing (also called “quantitative easing,” or QE) would be ending sooner than expected, and a repricing of risk assets resulted.
  
  
• First-time jobless claims fell to their lowest level since the COVID-induced recession began, with 444,000 people claiming weekly benefits. If the Fed can pare market expectations for QE in a gentle way, then economic growth figures will once again be good news. At the moment, however, good economic figures may be bad news for stock prices.
  
  
• Data on durable goods orders are released Thursday, along with consumer sentiment and personal income data on Friday. These are important metrics, though it is expected that personal incomes shrank now that stimulus checks have been distributed. Consumer sentiment will be important to see, as will personal spending data, as both of those directly relate to the “reopening trade.” As the economy reopens fully, and people are willing to go do things, we should see these figures begin to tick upward.
  

The Details

Earnings growth over the past quarter has been an encouraging development. More encouraging is that, rather than further extend prices (and thus valuations), investors have largely kept prices steady. This means that stocks are growing into their high valuations. At first blush this is a frustration for investors. However, if we think of valuations in the context of the commonly-used metric, the P/E ratio (price-to-earnings ratio, or the multiple investors are willing to pay for every dollar of corporate earnings), there are only two ways high valuations can normalize.

The first way is what we are seeing currently—prices remain steady while corporate earnings increase. This means the “E” in the P/E ratio increases while the “P”—price—stays the same. The overall valuation metric contracts because the number in the denominator is bigger while the numerator stays the same.

The second way valuations can contract is that the “P,” or price, can contract. This would also lower valuations, but at the cost of lower prices.

While watching markets stall-out can be frustrating, it is actually healthy because it gives valuations a chance to normalize, at least a little, in a way that doesn’t involve prices dropping. So, while frustrating, it is better than the alternative!

As I mentioned last week, rising interest rates as well as an end to quantitative easing by the Fed will both serve to shrink valuations. Earnings growth, then, is the only mechanism which can stabilize prices. Further progress on that front—espeically over the next two quarters—will be key.

Chart of the Week

There are multiple types of inflation. The first type, which most of us associate with inflation, is the monetary type: all else equal, more cash in circulation leads to higher prices for goods and services. The second type of inflation is demand-pull inflation: wealthier consumers demand more goods and services, and constrained manufacturing capacity creates higher prices. The third type of inflation is cost-push inflation: the inputs to manufacturing (like labor or commodities) get more expensive, leading to an increase in price to consumers.

Over the past 30 years or so, rather than raise prices, globalization has allowed companies to simply shift their production overseas, and this has been a severely overlooked factor holding back inflation. China’s percent of global GDP illustrates this quite well. As China gained more and more global manufacturing marketshare, the prices of consumer goods has been held low because manufacturing supply has grown substantially—holding demand-pull and cost-push inflation at bay. China’s rapid expansion of manufacturing capacity has given global companies a place to shift production to hold down their most expensive input: labor costs, and they have chosen to do this rather than raise prices. That shift peaked in 2015 and has begun to reverse, and as global economies begin to decouple from Chinese manufacturing, a significant deflationary factor may begin to subside. Of course, it may also be replaced by other low-cost manufacturers (like India, Singapore, Viet Nam, etc).

In any case, there is at least an argument to be made that existing deflationary pressures may have peaked and demand-pull/cost-push inflation may begin to exert an influence on consumer prices. Of more interest to me: 30 years is an entire career, so the veterans of finance have never managed money in an inflationary environment, and many will be reluctant to shift their thinking should that become necessary.

As I have often said, mental flexibility is one of the most important attributes investors can have, and I wonder if our current environment may be about to prove me right.

This document is a general communication being provided for informational purposes only. It is educational in nature and not designed to be taken as advice or a recommendation for any specific investment product, strategy, plan feature or other purpose in any jurisdiction, nor is it a commitment from Directional Advisors to participate in any of the transactions mentioned herein. Any examples used are generic, hypothetical and for illustration purposes only. This material does not contain sufficient information to support an investment decision and it should not be relied upon by you in evaluating the merits of investing in any securities or products. In addition, users should make an independent assessment of the legal, regulatory, tax, credit, and accounting implications and determine, together with their own financial professionals, if any investment mentioned herein is believed to be appropriate to their personal goals. Investors should ensure that they obtain all available relevant information before making any investment. Any forecasts, figures, opinions or investment techniques and strategies set out are for information purposes only, based on certain assumptions and current market conditions and are subject to change without prior notice. All information presented herein is considered to be accurate at the time of production, but no warranty of accuracy is given and no liability in respect of any error or omission is accepted. It should be noted that investment involves risks, the value of investments and the income from them may fluctuate in accordance with market conditions and taxation agreements and investors may not get back the full amount invested. Both past performance and yields are not reliable indicators of current and future results.

by Franklin J. Parker

The Summary

• This week is a pretty light on data—earnings are mostly done, and there isn’t much fundamental economic data posting. Of course, initial unemployment claims will be important, and the Federal Open Market Committee (FOMC) minutes post on Wednesday. Investors will parse those minutes for clues as to how members see the economy and policy evolving over the coming year.
  
  
• Last week was a big week for data. Namely, markets got figures for April’s job creation and inflation. Inflation was a surprise, with many pockets of goods and services beginning to see considerable upward price pressure. Prices for used cars and trucks, for example, jumped 10% over last month! The Fed has repeatedly stated that they fully expect short-term inflation pressure, but that they expect it to be transient. In that context, the recent inflation report is not of particular concern, however, investors must decide if they believe what the Fed has said, or if they think the Fed’s hand will be forced sooner than they have planned.
  
  
• Looking ahead, there is a bit of a respite from market-moving data. However, we are coming into late May and there is an old saying: “sell in May and go away.” Should investors heed that advice? I’m inclined to say “no.” My general thesis is that so long as the Fed is printing money, the bias in market prices is up, and the Fed is still printing money. While the summer is typically more volatile than the rest of the year, it can also deliver significant gains. If you had sold last year around this time, you would have missed out on 23% gains in the S&P 500 (and bought just in time for markets to go down 10%).
  
  

The Details & Chart of the Week

Let’s talk about stock valuations.

Obviously, stock valuations are extremely high. In fact, by one popular measure, stocks are more expensive than 95% of their history. Historically, stocks tend to deliver subpar longer-term performance when valuations are this stretched. Of course, valuations can remain stretched for quite some time (as they were in the late 1990s), so we can’t use valuations as a short-term timing mechanism.

But this does bring up the question of valuations—specifically what might cause them to shift back to normal. In a normal environment, investors would shift their valuation of stocks in direct proportion to their view of earnings growth. As you can see from the chart below, earnings growth affects the multiple investors are willing to pay for cashflows. For example, as growth expectations shift from 10% to 7.5%, investors would decrease their current valuation of stocks by 23%, all else being equal.

Of course, not everything is equal—especially in our current environment! In our current environment, I see at least three factors heavily influencing stock valuations. First, earnings growth is, of course, an important component. Second, low interest rates have served to pushed valuations higher. Third, the Fed’s increase in money supply has further served to stretch valuations. Let’s look at each component in turn (we’ve already considered the first), and then we may have at least some sense of how each component might influence market valuations.

Adding the influence of interest rates adds some complexity to our simplistic model of valuation above. Shifting both earnings growth and interest rates creates some interesting and nonlinear dynamics, as the chart below shows us. It also shows us an important point: valuations may stay high even if interest rates rise. It is not a foregone conclusion that valuations shrink when rates rise, as earnings growth can more than make up the change.

Finally, there is the influence of printing money. This is a considerably more difficult factor to pin down. I do have a framework for thinking about it, though I will be the first to admit it is still experimental, and there are lots of assumptions that must be made. Even so, let’s throw caution to the wind and charge ahead anyway.

Currently, the Federal Reserve is expanding the money supply by about 7.5% per year. Based on our back-of-the-envelope analysis, this yields an increase in market prices of about 3.5%, all else being equal. In other words, we can attribute about 3.5 percentage points of the coming year’s market growth to the Fed printing money at its current pace.

By developing a reasonable forecast for each of these components, we might have a better sense of how the Fed’s actions might affect markets in the coming years.

Based on this rough model, here are the consequences of various actions:

• For every 1 percentage point upward change in long-term earnings growth expectations, we should expect an 8% upward change in prices.
• For every 0.5 percentage point move upward in the 10-Year US Treasury yield, we should expect a 5% downward drag on prices.
• When the Fed stops printing money, we should expect a 4.5% drag on prices.
• A contraction of 2.5%in the money supply yields a 1.6% drag on prices.

As you can see, the strongest effect on market prices is still earnings growth expectations. However, that single effect can easily be overwhelmed by higher interest rates and an end to current Federal Reserve policy. Of course, as I mentioned, this is a very rough analysis.

The point is, higher interest rates coupled with an end to existing Federal Reserve policy creates a significant headwind for market prices. As I have long said, investors may do well to monitor these data points very closely, and adjust their portfolios accordingly.

As always, I would be delighted to open that conversation with you.

This document is a general communication being provided for informational purposes only. It is educational in nature and not designed to be taken as advice or a recommendation for any specific investment product, strategy, plan feature or other purpose in any jurisdiction, nor is it a commitment from Directional Advisors to participate in any of the transactions mentioned herein. Any examples used are generic, hypothetical and for illustration purposes only. This material does not contain sufficient information to support an investment decision and it should not be relied upon by you in evaluating the merits of investing in any securities or products. In addition, users should make an independent assessment of the legal, regulatory, tax, credit, and accounting implications and determine, together with their own financial professionals, if any investment mentioned herein is believed to be appropriate to their personal goals. Investors should ensure that they obtain all available relevant information before making any investment. Any forecasts, figures, opinions or investment techniques and strategies set out are for information purposes only, based on certain assumptions and current market conditions and are subject to change without prior notice. All information presented herein is considered to be accurate at the time of production, but no warranty of accuracy is given and no liability in respect of any error or omission is accepted. It should be noted that investment involves risks, the value of investments and the income from them may fluctuate in accordance with market conditions and taxation agreements and investors may not get back the full amount invested. Both past performance and yields are not reliable indicators of current and future results.