Zeller Kern’s Investment Monitor

A Look at Some Issues For the Second Half and Beyond

July 10, 2018

By Steve Zeller                           

Last week marked the completion of the first half of 2018 and many issues are taking hold or coming into the spotlight, not to mention the equity markets which continue to struggle outside of tech stocks and growth asset classes. According to Morningstar.com, as of the market close on July 5th, the Dow Jones Industrial Average was down -.34%, year-to-date, including dividends. The S&P 500 Index was up just 3.37%.

However, as it is clear of the major divergence between those indexes and the NASDAQ, technology stocks have driven that index up to a year-to-date performance of 9.89%. The Morningstar Small Cap Index is hot as well, with a year-to-date performance of 10.06%. And if you drill down further, you see that Small Cap Growth has been a more specific driver, with that Morningstar Index being up 13.98% year-to date. For that matter, all three growth equity asset classes, being Large Cap Growth, Mid Cap Growth, and Small Cap Growth, are the strong drivers for the U.S. equity market.

For the U.S. equity markets, we may see another push upward perhaps into new highs, before this current bull market is complete. The Wall Street Journal reported yesterday that the S&P 500 share buybacks are on a trajectory to soar to a new all-time high this year, which could give fuel to continue the market heading higher, even though the market has appeared to be in a multi month topping phase.

There isn’t any access to a “crystal ball”, but this divergence between technology stocks and the rest of the market is very reminiscent of the pre-2000 technology/Dot Com bust. For those that were weighted heavily in technology stocks at that time, the damage to their portfolios later that year and into 2001 was profound. All of the appreciation that was achieved, previously, no longer mattered after that. Worse yet, many investors couldn’t stand the emotion of missing out of all of those returns in that sector and decided to jump in towards the top. Those investors never recovered from their losses.

However, for those who didn’t drink the Kool-Aid, and either protected their portfolios and or diversified into out of favor asset classes, did favorably and at least, avoided the devastation that occurred within the tech sector.

The concerning situation this time around, is the potential for an abrupt decline. Back in 2000, there was plenty of warning for those that paid attention to certain indicators. But currently, the market is much more automated (robots) and program trading is much more intense. The result is what occurred at the end of January, when the market rose significantly earlier that month and then abruptly reversed and declined significantly without any warning.

Those that are heavily invested in the technology sector have clearly reaped the rewards, but at what future price, especially if your intentions are to hold longer term?

Outside of the U.S. Equity markets, things are much less impressive, with most of the International Indexes in the red for the year. Some of the negative stats include the MSCI EAFE Index down -2.96%, the MSCI Latin America Index down -11.44%, the Heng Seng HSI Index down -4.95%, and the MSCI Japan Index down -7.31%. Those diversified in International Equities have had some cold water thrown on any portfolio sizzle. Throw in an allocation of bonds into the portfolio, and the results are likely even more humbling, with the Morningstar US Core Bond Index being down -1.53%, year-to-date.

So, in looking forward to the second half of 2018, things could get pretty interesting. Either for better or for worse, that remains to be seen. But if you consider the change in attitude of countries toward each other with the trade wars, interest rates entering into a rising trend, and the Central Banks which are now deciding to exit the “quantitative easing business” making for an interesting back drop. The Bank of Japan has announced that it is ending its quantitative easing after having purchased approximately 75% of the Nikkei Index ETFs, and being the biggest purchaser of its own sovereign debt. Throw into the mix that Japan is currently sporting a Debt to GDP ratio of over 250%, and one can conclude that they have a challenge before them. (Click all images to enlarge)

Enter the Fed into the mix and it gets even more interesting. Just as the economy is finally turning around, the Fed is unwinding its balance sheet. At the height of its asset purchasing, registered assets on its balance sheet totaled north of $4.4 trillion. Since that peak occurred a few years ago, it is now engaging in what they refer to as “balance sheet normalization.” This will be an attempt to reverse, over an unspecified number of years, a large portion of the QE that was done in five and a half years. During the QE period, the Fed purchased approximately $3.4 trillion in Treasury securities and mortgage-backed securities. Recently, the “unwind” has become noticeable, with the Fed’s balance sheet dropping $29.4 billion over the past four weeks. The total drop in assets, since October, has mounted to $171 billion. The current asset total on their balance sheet is now at $4.289 trillion, which is its lowest level since April of 2014. This is according to an article recently published by Wolf Richter of Wolfstreet.com.

The Transformation of Our Workforce

Another major issue is the economy, and so far, it’s mostly good news. GDP has improved, corporate revenues are up, corporate profits are up notably, and unemployment is way down. According to a recent article posted in the Wall Street Journal, the U.S. added 213,000 jobs in June. The unemployment rate edged up to 4%, from the previous 3.8% level. The reports are mentioning that companies are vocal about the shortages of truck drivers, machinists, and other tradesman.

But, one aspect of all of this is that wages are moving, but at a slower than expected rate. Why is that? Well, a couple of reasons:  Even though there are shortages in some areas, there are more lower-paying jobs, as the shift from high paying baby boomers to younger workers who earn less in many instances. Another reason is the re-entrance of people into the work force. An estimated 600,000 people entered the labor force, according to a recent article Written by Jeffry Bartash of Market Watch, bringing the increase of re-entries into the work force to 2 million over the past twelve months.  So, an estimated 600,000 people are looking for jobs. The supply of labor is still existent, although scarce in parts of the country and in some industries; the labor force has been able to expand by an average of 215,000 new jobs a month over the past year. Another statistic worth mentioning is that there are approximately126 million able-bodied people within the U.S. that are between the ages of 25 and 54. That produces an estimate of approximately 81.8% of this population is in the workforce. Theoretically, there is still an estimated 3 million potential workers that can enter back into the workforce according to the Market Watch article.

It is possible the rise in wages will begin to accelerate. According to the Wall Street Journal, average hourly earnings increased 2.7% in June, from a year earlier, and even though it is slightly below expectations, wages have increased at least 2.5% for the past 16 of the past 17 months. This may begin to squeeze profitability moving forward. Please reference this Wall Street Journal article, “Wage Gains Threaten to Squeeze Retail, Industrial Profits”.

Another reason for the lack of pressure on wages to increase, is the continued disruption within the brick and mortar retail sector, mainly caused by Amazon and the shift in online shopping habits of consumers. Regional department stores and malls are folding, big time. An example given to us last week was the Magic Mart stores across West Virginia, Virginia, and Kentucky, along with their distribution center which will all be shut down by November 1st and liquidated. The store chain is 97 years old and consists of 16 stores. Another regional chain that is going out of business is Bon-Ton Stores, which operates throughout 23 states. It is estimated that 24,000 employees are losing their jobs. The good news is that Amazon is most likely choosing Indianapolis or a northern Virginia location to be their headquarters, so hopefully it will inject commerce back into that region.

If major mall participants such as Macy’s, Sears, Kmart, and J.C. Penny are included, there is no doubt that the commercial real estate firms and REITs that own these properties are under pressure. Oh, and let’s not forget to mention Toy R’ Us.

Also, affecting the wage levels has been technology replacing the employee for more and more tasks. We will discuss this later in this issue.

The other major issues we feel are worth mentioning this week is, again, the coming pension crisis, and the debt levels (which we discussed in the last issue), the trade wars and the coming fourth technological revolution.

The pension crisis is real, and it must be dealt with. The collectors and future collectors of state pensions should be demanding that there be reform, if they know what’s good for them. Outside of Illinois and perhaps New Jersey, the pension systems still have a slight chance of not imploding, if they reform themselves, in our opinion. For those who are planning on a pension, just keep in mind that birth rates have plunged to near or below replacement levels and the average life span has increased to 80 and beyond. Throw in a record number of retirees jumping onto the retirement bus, and you have deepening challenges for pension funding ahead. It might be to the best interest of recipients if they push for reforming the system they’re participating in, it would probably be worth it in the long run.

We plan on devoting an issue of the Monitor to the pension problem, so we’ll move on. But, this will continue to be a major issue going forward.

The next issue that is positive but is a disruptive trend that is falling into place is the so called “Fourth Industrial Revolution.” There is a handy article in the Visual Capitalist that discusses this subject. This fourth revolution builds upon innovation within several critical areas that will revolutionize industries and nations all over the globe. The revolution includes: artificial intelligence, the further internet of things, self-driving vehicles, nanotechnology, renewable energy, quantum computing, and biotechnology. We are optimistic on the net effects of this coming wave in technology, but of course, not without disadvantages mainly from a disruptive standpoint, and a societal standpoint. The net effects for quality of life should still be positive.

The other issues to contend with, of course, for the second half of this year will be the direction of the economy, the trade wars, and will we be heading into a “bear market?

As it stands now, the economy appears to have steam left in it. Regarding the equity markets, we just may get another push upward before the bull market cycle is complete. However, this is still all looking like activity within a late cycle. We’ll have to see.

Looking back on last week 
Last week was somewhat of an odd week with having a major holiday on Wednesday pretty much disrupted most of the normal flow, causing overall volume to be quite light which is expected of course.
Most of the action last week was after the holiday as we saw an accumulating to the bulk of the returns for the week with the S&P finishing up 1.52%.
But as Friday traded on, we saw substantial moves in healthcare, utilities, telecom, not to mention that the yields on the 10-year declined to 2.8%. The decline in yields helped to lift the real estate sector 1.8% and markets stayed steady and higher into the close on Friday.
The other primary factor that was driving markets last week was crude oil which moved close to $75 a barrel but saw little backfilling on Friday. But overall, the economy and demand for assets continue are still driven primarily by buybacks by US corporations.

Best Wishes,

Zeller Kern Investment Committee