Category: Uncategorized

by Franklin J. Parker, CFA

The Summary

• Investors will be closely watching the progress of the latest stimulus package. The current proposal is worth around $1.9 trillion. Though Congress is out this week, the package has cleared initial negotiations and appears to be on track to pass via the reconciliation method, which only requires a simple majority. The bill is expected to be assembled by the House Budget Committee this week, with passage in the House expected next week. Markets are likely to trade on news, pricing the likelihood and timing of passage.
  
  
• Wednesday has a couple of important data drops: the Fed minutes, and the producer price index. The Fed minutes will be parsed by market participants looking for clues to when/if policy normalization is to begin. Producer price indexes are usually viewed as an early indicator of inflation, though some of that link has been weaker lately. Either of these could move markets.
  
  
• Earnings have been generally good (with about 75% of companies having reported): more companies are beating their estimates than average, and they are beating these estimates by a larger margin than average. No big surprise, tech and financials have posted the largest percentage of “beats” across sectors, while energy and real estate have posted the fewest percentage of “beats”. Still, 67% of energy companies have beaten earnings expectations, which is still quite good. Interested folks can read more at FactSet.

The Details

As we’ve discussed before, extreme market valuations are being supported by the central banks. Low interest rates and continued expansion of the money supply (printing money) serve to keep financial markets up. The latest round of stimulus proposals, then, are an important component of this continued market rally, and investors are likely to push prices around in response to any news surrounding it.

To fund stimulus, Congress authorizes the US Treasury to borrow money. In the past, it was investors (both domestic and international) who lent that money to the United States. In recent years, however, a significant percentage of that money is lent by the Federal Reserve. The Fed creates the money and then lends it to the US Treasury. In this scenario inflation becomes the major constraint on spending–higher inflation limits the Fed’s ability to print money, which limits the Treasury’s ability to borrow, and ultimately hinders Congress’ ability to spend. In the end, this pushes investors to watch inflation data very closely.

This is why markets are heavily influenced by central bank commentary (hence the importance of Fed minutes scheduled to post on Wednesday) and inflation data. Hints of the Fed pulling back spending would lead investors to push down stock valuations.

On the upside, earnings are posting generally better than expected. Most companies in the S&P 500 have posted results, and most of those are better than anticipated. Even energy, the laggard over the past year, has seen 2/3rds of companies post earnings which are better than expected.

It is my view that markets will continue to be bolstered in the coming months by the Fed and Congressional stimulus. There are certainly risks facing investors, and ultimately your goals and objectives will determine your course, but I see more upside than downside risk in the coming months. In my view (which can change in a moment, by the way), investors can use market dips as entry points.

Chart of the Week

As frigid temperatures grip the Southern US this week (parts of Texas are colder than Alaska!), energy markets have been sent on a wild ride! This week’s chart comes from Bloomberg, and it shows the spot cost per megawatt-hour of Texas electricity–a 3400% jump within a few hours. Oil and natural gas prices are also getting a boost from the sudden cold snap.

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

• Jobs data last week showed considerable weakness in the labor market through January. While this would normally be bad news, poor data provides cover for the Federal Reserve to continue printing money (called Quantitative Easing or QE) and Congress to send cash directly to households. Both of these are very positive for market prices in the short term, and investors will continue to watch Washington for signals that further stimulus is still on track.
  
  
• This week we get a large percentage of the S&P 500 reporting earnings, including consumer brands like Coca-Cola, Pepsi, and Walt Disney. Investors will watch these calls very closely. Big tech posted absolutely stellar earnings last week. AMZN was the superstar, but market reaction was muted with Bezos’ announcement that he is stepping down as CEO. GOOGL posted earnings 45% above this time last year (which was pre-pandemic)!
  
  
• Inflation data posts on Wednesday. Inflation has become a much more important data point that usual because it is the only real constraint on central bank activity. If inflation begins to surge, investors will expect the Federal Reserve to reign in QE, which would force investors to re-evaluate lofty stock valuations. In short: hotter inflation leads to a stock and bond market selloff, in our view.

The Details

Though it has been improving, no matter how you slice it the fundamental economic data is pretty bad. There are several data points which are at their worst levels since records have been kept. For example,

• Weekly initial jobless claims,
• The headline unemployment rate, and
• The year-over-year contraction in consumer spending,

are all at levels never-before seen. You couldn’t guess that by looking at stock and bond markets, though! The level of divergence between stocks and the real economy is staggering. It only makes sense when we consider the role of newly-printed cash flooding into the economy. Most of that cash finds its way into financial markets sooner or later, and it serves to push prices higher. My own research shows that, all else equal, giving investors more cash makes them perfectly willing to pay a higher price for the exact same security.

So, while I am indeed concerned about valuations (stocks have only been more expensive twice in history: 1929 and the late 1990s), these valuations are sustainable so long as the Federal Reserve keeps doing what it is doing. When current policy ends, it seems likely to me that current valuations will become unsustainable and a market dip becomes considerably more likely. Our portfolio positioning will be heavily influenced by our outlook on Fed policy.

Chart of the Week

With all the talk of Federal Reserve policy and its effects on asset prices, I thought it prudent to also discuss consequences of this policy. Inflation is, of course, the primary concern (and my nuanced thoughts on inflation deserve an entire post). More pressing, however, is the rise of “zombie” companies. In a nutshell, zombie companies are firms which have existed for five or more years and do not make enough revenue to cover the cost of their debt. This means they are forced to constantly seek new capital from investors to continue operating.

The Bank of International Settlements has now published several papers on this topic, the most recent of which I feature in this week’s chart of the week. Banerjee and Hofmann document the rise of zombie companies in various economies which they directly attribute to central bank policy of low interest rates and easy money. They have found that the share of zombie companies in the global economy has grown from around 4% in the early 1990s to around 16% as of 2017. They also find (unsurprisingly) that zombie companies invest less in physical capital (factories, equipment, etc), are less productive, and are considerably more leveraged than their non-zombie counterparts. In addition, their performance deteriorates significantly as they age.

In the end, an economy full of zombie companies lowers productivity, wage growth, and economic dynamism. That is, of course, not preferable to a dynamic and productive economy. In the end, this may be the most significant immediate side-effect of central bank policy.

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

When most people think about risk in an investment context, they think of one thing: losing money. What most of us never stop to think about is why. Why are we afraid of losing money?

I’ll admit, at first glance this seems like a dumb question. No one likes to lose money, so that must be risk. But by digging deeper we can reveal the true nature of risk. If we can understand what risk really is, then we can both manage it and our own psychology better.

No one invests for the fun of it. We invest with some end in mind. We invest in order to accomplish our longer-term financial goals. Risk, then, is different from market ups-and-downs (which is the classic academic definition), and it is different from just “losing money.” Risk, at heart, is the probability that you do not achieve your goals. It is not that losing money is uncomfortable in and of itself. Rather, we don’t like losing money because it means we are less likely to achieve our goals!

This is a fundamental realization of goals-based investing, and it leads to a few differences in how we at Directional Advisors approach money management.

First, it means that we can quantify downside risk in your investment portfolio. What market losses would derail your goals? When are investment losses too much? Rather than guess at the answers to these questions, we can calculate them. By calculating them, we can take steps to mitigate the risk of unrecoverable losses in your investment portfolio.

This also leads to better management of our own psychology. We are afraid of investment losses because we don’t know if we can recover in time to achieve our goals. That is why all investment losses feel like too much. By quantifying downside risk, we can better understand when it is appropriate to worry and when market downswings are within our tolerance. Furthermore, by taking steps to mitigate the risks of excessive investment losses we can even further decrease the amount of worry. While there are no guarantees in life, this can go a long way to easing our stress about investing.

Second, this fundamentally changes how we organize our investments. Portfolios are put together in a way that maximizes the chances of hitting your goal. While your risk tolerance should be part of the conversation, it should not be the primary metric for managing your portfolio. Imagine going to the doctor and getting a battery of tests. Your doctor explains the problem but informs you that she cannot proceed with the necessary treatment because the pain-tolerance questionnaire you filled out at intake indicates that you are too conservative to proceed! While your comfort with market volatility is a part of the conversation, it should not be the only deciding factor in your investment portfolio.

Third, goals-based investors can recognize that markets are not tame. There are moments when markets can erase years of saving and sacrifice. We need to recognize that risk up front and take steps to mitigate it in your portfolio. We believe there are times to be cautious and times to be more aggressive. What to do when is determined by our outlook for markets, and also the specifics of your goals.

In the end, investment risk is perceived and managed through the lens of our goals. By better understanding what risk is, we can better understand how it should be managed.

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.

Franklin J. Parker, CFA
chief investment officer

The Summary

• The Volatility of last week is likely to continue into this week as investors watch for the risk that large fund failures lead to a systemic problem.
  
• We get a read on the various sectors of the economy in the first half of the week, and a read on the health of the labor market in the back half.
  
• Though recent volatility may be unnerving, we believe the Federal Reserve remains committed to supporting markets. In our view, the Fed and the promise of further stimulus from Congress keeps an upward bias in prices for the time being. We see the recent downswing in stocks as an entry point for patient investors.

The Details

Last week’s big news was a classic David vs Goliath story: an army of retail traders took on big Wall Street hedge funds… and won! Their weapon was GameStop (GME), a brick-and-mortar video game retailer which has been in decline for some time. Hoping to profit on the decline, many hedge funds had sold the stock short. Coordinated through social media, retail traders began furiously buying the stock, pushing the price higher and triggering what is known as a “short squeeze.” In an effort to limit losses and make good on their commitments to return the shares of GME, the hedge funds had to quickly buy the stock back, driving the price of GME still higher and triggering still more short-sellers to buy.

The price of GME was pushed so high that many of these funds, which use quite a lot of borrowed money to leverage their returns, were in danger of bankruptcy. Because bankrupt firms cannot make good on their obligations, investors have begun to worry about the ability of these funds to make good on their commitments to others in the marketplace. It was this danger of systemic risk that pushed brokerages such as RobinHood, E-Trade, Interactive Brokers, and TD Ameritrade to curtail trading in not just GME, but other stocks as well.

I see the market volatility that ended last week as likely driven by investors repricing this systemic risk, and an effort by levered funds to raise cash quickly by selling their higher-quality investments. While this volatility may continue in the near term, and while there are systemic risks in play, it is my view that this downswing will be short lived. Liquidity concerns are likely to be met with Federal Reserve policy, and stimulus payments tend to bolster prices as well. Investors can use this moment as an entry point for cash, or simply wait it out. Of course, as the situation develops, this advice may develop along with it!

Chart of the Week

I have been surprised by the very rapid recovery in US manufacturing. Interestingly, however, the decline in manufacturing was no worse than it traditionally has been in a recession. In fact, 2008 saw a more significant decline in manufacturing, and that was a recession caused by a credit crunch! The recovery has been among the quickest, however, and though a only small piece of the US economy, manufacturing tends to precede other recoveries in other sectors. This bodes well for the fundamental economic outlook.

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.