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All Posts By Cliff Jarvis

Bonds: The Long and Short of It

Bond funds are often lumped together as one.  However, they are actually a range of very different investments.  This post will address only investment-grade bond funds which have a low probability of default as these are bonds that are issued by large and established corporations and the U.S. government.

It is important to know how changing interest rates affect short-term and long-term bond funds differently.  Short-term bond funds hold individual bonds that mature and ‘roll’ quickly into new bonds with current interest rates. This means short-term bond funds adjust relatively quickly to changing interest rates, so the principal risk is relatively low.   Short-term interest rates are set by our Central Bank as policy.  Long-term rates, however, are set by market forces and investor expectations.  Our Central bank influences, but does not control long-term interest rates. The interest rates on long-term bonds do not change for the length of their maturity.  What must adjust to changes in interest rates is the current price of the bond.  Higher interest rates mean lower current bond prices and vice versa (refer to my posts on duration).

What is important to know for today’s investors is that the Federal Reserve has raised short-term interest rates meaningfully off of zero over the last year or so and plans on continuing this trend.  As a result, some short-term investment grade bond funds are now offering SEC yields of around 2.5%.  However, long-term interest rates have only risen somewhat and, as a result, long-term investment grade bonds are offering an SEC yield of only 3 to 4%.  It was expected that long-term interest rates would rise accordingly with short-term rates, but thus far they have not.  Should this change, there is a real potential that longer-term interest rates will rise and the price of long-term investment grade bonds funds would be negatively impacted.

Investing in short-term investment grade bonds may currently have a lower dividend, but offer less principal risk.

Buybacks Drive Stocks Higher

The tax cuts that went into effect this year lowered the corporate tax rate from 35% to 21%. Of course, most corporations were not paying that, the effective rate that was actually paid was much lower. However, the new lower 21% official rate allowed corporations to lower their effective rate even further and boost earnings. Also of great importance, it allowed for bringing overseas earnings back home for a limited time at a substantially reduced tax rate. While the goal of this ‘bring the money home’ legislation was to increase investments in plants, equipment, and jobs (which is happening) much of the cash is going to stock buybacks.

Stock buybacks are driving the stock market higher. Corporations are buying shares in the open market creating demand and driving prices higher. Additionally, when corporations buy their own shares they ‘retire’ these shares leaving fewer shares outstanding. Each remaining outstanding share then represents a larger piece of the corporation. Therefore, when total earnings are reported, a smaller number of shares are divided into them. This increases earnings per share and further boosts share price.

Unlike paying out dividends to shareholders, buybacks do not involve immediate taxation. Dividends are taxed up to 20% while buybacks can result in meaningful capital gains in share price which will only be taxed when they are eventually sold. Buybacks can be a very positive way to reward shareholders with earnings in excess of what the underlying corporation needs to finance ongoing business plans.

So far this year, buybacks are running at a record pace.

Furthermore, and not quite as positive, several years of ultra-low interest rates have encouraged corporations to borrow money to buy back shares. This has resulted in record levels of debt carried by U.S. corporations. While stock buybacks help boost share price in the short run, this incurred debt may be problematic over the long run as more and more money is going towards interest payments. This leaves less for ongoing business needs, especially in recessionary times.

While there is no equation to forecast the effect of buy backs on future share prices, it continues to be a very strong positive in the short run.

Patience is an investment strategy

“The secret to investing, is to sit and watch pitch after pitch go by and wait for the one in your sweet spot. If people are yelling, ‘swing, you bum!,’ ignore them.”

Warren Buffet (Source)


I remember, years ago, a client called and exclaimed: “This market is on a rocket ride, you better get on board.” At the time, the stock market was trending higher and higher with disregard for how much the price (of stocks) were in excess of their actual value. The market continued to go up until it didn’t. And, as history shows, it didn’t end well. The trend exhausted itself and, in the spring of 2000, it turned, suddenly and dramatically. In 2007, the same scenario happened again.

Recently in an article by article by Rob Arnott Vitali Kalesnik and Jim Masturzo they pointed out that when the price of stocks is extended over their traditional value measurements it “is not a useful timing signal for market turning points, but is a powerful predictor of long-term market returns” and that currently “no matter what adjustments we make, the U.S. market is expensive.”

But wait, rapidly rising markets can be a great way to make money? As we are seeing, overvaluation can continue for some time.

Per wisdom of Jeremy Grantham, a legendary value investor: “I recognize on one hand that this is one of the highest-priced markets in U.S. history. On the other hand, as a historian of the great equity bubbles, I also recognize that we are currently showing signs of entering the blow-off or melt-up phase of this very long bull market.”
“Bracing Yourself for a Possible Near-Term Melt-Up.”

So what to do?

The pull of this rapidly rising market is too strong to ignore. The fear of missing out (FOMO) is irresistible. You’ve got to be in. You’ve got to do it. Prices may well move much higher and stay there! But know the stock market is currently no bargain. Maybe being patient and waiting to buy when prices are below values is an investment strategy.

I believe now more than ever it is important to know what you own so you can stay focused on the long-term. Stay diversified, do not over-invest, stick with quality, and wait for the ‘fat pitch’. Do not let the fear of missing out cloud your long-term investment decisions. If you are not going to try to time the market with short-term trades, do not be afraid to wait for a fair price.

The Art & Science of Investing: Bonds

In our previous post, we explored the high-level art versus science debate that is occurring in the finance community and how it impacts equity valuations.  This post delves into some of the issues as they relate to bonds and fixed income.

Although the bond markets are multiple times larger than the stock markets, they receive far less attention. These markets are usually set by free market forces. However, today it is no secret that Central Banks are manipulating interest rates in an effort to artificially stimulate demand for loans in an effort to provoke greater economic activity. Consequently, interest rates are at 100-year lows. These Central Banks need to hold interest rates down to avoid paying higher rate payments on the ever-increasing mountain of government debt. Currently, this debt is currently over 100% of the entire nation’s GDP (If interest rates were to rise, interest payments on the debt alone could consume the entire amount of taxes that are paid).

The plan of the Central Banks around the world is to create new money, buy bonds, and keep interest rates low until the economy revives (Quantitative Easing). Inflation will then pick up along with higher wages. Deficits will subside due to higher taxes from a growing economy. Total debt will shrink relative to a larger economy and interest rates could slowly rise to free-market levels. Again, politics influences economics and politics cannot be reduced to computer models.

For the average investor, duration and must be considered. Duration is a very important concept for bondholders. It measures the degree of risk of principal loss should interest rates rise from our current historic very low levels. For example, if interest rates rose by 1%, an investment-grade bond with an SEC yield of about 2.4% and duration of about 6 years could lose about 6% of its market value.  Given the meager 2.4% SEC yield that is not much reward for that much risk. Currently, government policies are holding interest rates at depressed levels. Should interest rates rise, many investors would be left with unexpected losses.

Given the potential explosion of future events, a human element is needed. It has become increasingly obvious that some things are not reducible to mathematical equations. Investment planning is an art that requires a human touch not just mathematical science.

The Art of Investing: Stocks

In our previous post, we explored the high-level art versus science debate that is occurring in the finance community.  This post delves into some of the issues as they relate to equities.

The Science Argument: Valuation. There is a camp of investment managers who believe that the value of a stock is simply the present value of future earnings. After all, it is no more than partial ownership of a business. Viewed as an investment, the long-term stream of future cash flow must justify the initial cost of the investment. Therefore, stocks have a fair value based on past, current, and estimated future earnings. Historically, there has been a fair value for the major stock indexes which is in the area of 15x’s earnings. Higher than 15x’s earning, the stock market is expensive; lower than that, the market is cheap. Currently, the major indexes are over 20x’s earnings.

The law of fair valuation states that, while actual prices will fluctuate, fair value will inevitably win over the long-term. But in the short term which can last many years, perhaps even a decade, this law is at best obscure. This brings into play the second, and often the more important rule.

The Art Argument: The Trend is your friend.  As mentioned, in the short term, value may not be the best indicator. Instead, we in believe momentum and mass psychology rules. It is currently ruling up. Once a direction is established, either up or down, it takes on a life of its own. Numerous factors have combined to yield 10 years of low volatility. Stock market sell-offs have been minor despite subpar economic growth and high valuations. Many argue that an important factor is that central banks around the world have been openly buying assets (bonds & stocks) to boost prices and to induce economic growth. This intervention induces another factor of stock buy-backs on the part of our major corporations to boost earnings per share; this has created enormous upside momentum. Furthermore, it is common knowledge that the Federal Reserve will support asset prices when necessary (the Bernanke Put).

As a result of these influencing factors risk awareness has been dulled and, in the short term may be rightfully so. The stocks markets continue to smoothly chart higher and higher. But is the concept of fair value still lurking out there?   When, if ever, will it return?  But in the meantime, there may be a great deal of money to be made. And, after all, many, many good things are happening that could rightfully drive the markets by increasing earnings and thus fair value.

Further complicating proper investment decisions is ever-changing government policy. For example, our government is now in a heated debate over tax policy. If they lower corporate tax rates, what will that do to boost earnings? If the abundance of cash reserves held overseas by corporations are induced to come home, what will that do to stock buy-back programs and economic expansion? Politics influences economics and politics cannot be reduced to computer models.

So can investment planning be reduced to math inside of a computer model? We would argue that a human element is needed. It has become increasingly obvious to us that some things are simply incomprehensible and that investment planning is just as much art, as it is science. This is especially true in today’s world where headlines are manipulated and central banks of governments are overriding free market forces.


I thought I would do a review of recent earnings of the S&P 500.

Recall that earnings* for the 500  largest U.S. companies, the S&P 500,  are reported in two ways.  The first is GAAP (Generally Accepted Accounting Principles) earnings. This number is the one that is reported to the SEC. The second is operating or non-GAAP earnings. The non-GAAP earnings are what analysts follow because it adjusts for one-time events and is said to more actually reflect their business.

For the 2nd quarter of 2017 which just ended, blended earnings are coming in at about $104 (GAAP) earnings and about $116 (operating)earnings; the latter is almost always higher as companies can exclude items they do not like to report.  This is up from $87 (GAAP) earnings and $115 (operating) earnings for the 4th quarter of 2015 which were low, in part, due to the hit energy companies took when oil prices crashed. In the 3th quarter of 2014 earnings came in at $106 (GAAP) and $115 (operating).  Earnings have recovered to their previous peak reached several years ago while the market has moved higher.

This puts the Price/Earnings ratio** of the S&P 500 at 24x’s (GAAP) and 22x’s (operating). The long-term average Price/Earnings ratio is about 15x’s earnings, which is closer to what I have labeled “fair value” in previous entries (see below).

*all earnings are Trailing Twelve Months (TTM)

**The Price/Earnings ratio compares a stock’s 12-month trailing earnings to the current price.

The Federal Reserve says one thing, the yield curve the other.

Final 4th quarter GDP came in at 2.1% leaving the 2016 growth rate at 1.6%.  The Atlanta District of the Federal Reserve is predicting less than 1% growth for the 1st quarter of 2017.  That is not good.  Despite this, the Board of Governors of the Federal Reserve in Washington has begun raising short-term interest rates, citing indications of a stronger economy ahead.  However, the yield curve (which plots the interest rates of bonds maturing from now to 30 years out) is telling a different story.  While the short term rates on CD’s and money market rates move with the Fed’s decisions, the interest rate on the 10-year Treasury bond is very important and is driven by real-world activity.  This is the one to watch.  Mortgage rates and other important benchmarks key off of this rate more than the Fed’s position on short-term rates.  The interest rate on the 10-year Treasury bond has risen from a very low 1.4% about a year ago to 2.6% in the past month (remember, the current price of a bond goes up when the interest rate goes down and vice versa). However, the interest rate on the 10-year Treasury bond has started to stall and may well roll over and head back down … not an encouraging sign for increasing economic activity (but good for the current price of many bonds).  Long-term interest rates typically rise with stronger economic activity, but they are lagging.  The yield curve showing longer term interest rates vs. short term rates remains somewhat flat.

The stock market still sees things differently. Stock prices have risen despite years of disappointing earnings (see below “5/16/16: Is Fair Value Obsolete?” ). President Trump’s election has further boosted stock prices due to a hopefully optimistic outlook.

A great deal depends on the effectiveness of our new President’s economic policies and whether they will be implemented or not.  While the stock market may be optimistic, the bond market has not been so inclined to follow suit at this time.  Should the economy continue on its slow growth path similar to the last 8 years or so, interest rates may stay low (or even go lower) perhaps, making bonds a safer place to invest (remember, the current price of  bonds goes up when interest rates go down and vice versa).  Interest rates going  lower when they are already near historic lows seems implausible but possible.

Italy, Again, Still

“……the bad-loan problem is mainly due to a 25 percent plunge in industrial output in the six years through 2014.

Italy’s GDP remains about 8 percent below its pre-crisis peak reached in 2007.” (link)

Back in 2012 and 2013, I wrote that the European common currency, the Euro, would fail. I wrote that a Europe strapped into a common currency designed for political reasons would prove itself to be unworkable for economic reasons. Countries like Italy could not be locked into the same currency as Germany. I wrote that Italy needs its own currency so it can continuously devalue to keep the cost of its goods competitive with those from Germany (devaluing a currency makes everything in a country cheaper for everyone outside of that country). Before the Euro, Italy was able to devalue its currency, the Lira, and thus keep the price of its goods relative to the price of German goods and services. However, the Euro locked Italy and Germany into the same currency. While the cost of Italian goods rose, Germany’s cost held steady. Instead of facilitating trade, Italian industries were outcompeted and hollowed out. Italy began to import more and export less. (Un) Fortunately, because Italy’s currency was now the Euro and devaluation was not possible; banks everywhere were willing to lend Italy money without abandon. While exports (earnings) and their industries declined, the government bloated up with debt/spending to fill the void left by their declining productive sector. Government expansion (and government debt) maintained the illusion of economic activity. The problem was solved (or better, put off) for a while. Government did what government does best; it makes things worse.

Then the European Central Bank (ECB) stepped in and, you guessed it, made things worse. The ECB decided to buy massive amounts of bonds from all the European nations and flood the system with money with the intention of reviving these economies. This has put off the inevitable default of the massive amount of debt Italy found itself in. Of course, this has not worked. Italy has not defaulted, but it’s economy is sick because political forces are strapping it to the death grip of the Euro. In order to compete, Italy must lower its costs. Instead, the current plan is to remain in the Euro and grind down wages, benefits and everything else (austerity). This is not working and will most likely end in a popular revolt. On the other hand, if Italy was to leave the Euro and pursue its own currency, Italy’s new currency, the Lira would devalue. Devaluation would immediately realign relative prices. The cost of Italian goods and services would become cheaper while the costs of creditor nations goods and services such those from Germany would become more dear. Floating currencies adjust to keep countries competitive and thus working without grinding ‘austerity’.

Today, Italy is sick. The economy has not grown in years, government debt has exploded, and the banks are full of defaulted loans. Italians are increasingly holding cash and/or gold because their banks are failing. Non-performing loans are approaching 20% of total gross loans; and under the current European Laws, the Italian government is not allowed to bail out the banks. So many depositors could lose their savings.

Watch Italy. As I wrote about several years back, the Euro is a failed experiment. The partial breakup of the Euro is not the end, it is the beginning. The immediate pain of going back to a devalued Lira will free Italy from past mistakes and reset its economic path to future growth. Currency exits have happened before and devaluations are commonplace. It is inevitable. A devalued Lira will make vacations in this beautiful country a bargain and a flood of tourists will put Italy on a road to recovery.

Britain Exits

Sixty years ago, the nations of Europe began uniting under one European Union.  The first goal was to define themselves as Europeans instead of separate nationalities which repeatedly started a war with each other. The second goal was to integrate their economies to achieve greater prosperity for everyone. The European Common Market was formed and it worked for a while. Over time a total of 28 countries joined. The next major step was the creation of one common currency called the Euro. 19 of these countries discontinued their currency and adopted the Euro (the Eurozone).  The goal here was to further simplify financial transactions across Europe by using just one currency. While Britain was the second largest economy within the European Union, it never joined the Eurozone and kept its own currency known as the Pound.

Each European nation not only had its own national government, but also the new supranational government created by the European Union. Unfortunately this additional layer of government formed by the European Union grew and metastasized into an overreaching giant that regulated, interfered, and constrained all aspects of activity.  Due to this and many other reasons, the European economies are in decline.  This, in addition to the unmanageable flood of immigration mandated by the European Union’s open border policy, brought Britain to the edge. Last week the British voted to leave the European Union and all of its rules.

The question now is, will Britain leaving the European Union for the sake of self-determination bring economic calamity or long term prosperity? And what effect will that have on the rest of the world?

Is Fair Value Obsolete?

The Fair Value concept holds that stocks, and the market in aggregate, have a value based on past, current, and future estimates of earnings. To oversimplify, when you buy a stock, you buy a piece of a business. The questions to ask when buying a stock are what has the business earned, and what is the business expected to earn in the future? The stock’s fair value is then determined by the current and expected earnings. This is measured by the Price/Earnings (P/E) ratio.

For the S&P 500, which consists mostly of the country’s 500 largest corporations, the average historic P/E ratio has been about 15 times its GAAP (see previous entry) earnings. But in the last 20 years or so, the P/E ratio has started to vary wildly, reaching extremes in 2000 and 2007. Today it is 24 times its GAAP earnings. The S&P 500’s price is overvalued compared to what Fair Value would suggest.

Is the concept of Fair Value obsolete? Why is the market’s P/E ratio significantly higher than the historic average? Is it that our government now has a policy of supporting the stock and bond markets? Is it that the introduction of new computerized trading programs by hedge funds has raised the level of Fair Value?

To return to Fair Value’s historic average either stock prices must retreat or corporate earnings must rise. Currently, the market is up while our economy has not yet delivered strong corporate earnings. Hopefully, earnings will rise rather than stock prices dropping because over the long run, I suggest Fair Value will ultimately prevail.