Welcome to the August newsletter! Today, we’re going to review the optimism around unemployment numbers, the market’s reaction to presidential elections, and why we’re watching out for an inverted yield curve. Let’s jump right in!
The stock market remains in a bull market even as the correction that started on January 29, 2018 continues. The all-time U.S. stock market closing high was on January 26 of this year. As of the August 2 close, the S&P 500 Index is only 1.6% below the January 26 closing high. The bond market, though, is in a bear market with interest rates slowly rising and existing bond prices slowly falling.
Employees contributing to their employer’s retirement plan or IRAs should continue with their weekly or monthly contributions. The economy continues to grow successfully without runaway inflation. However, some tech stocks have been getting hammered for those who own these individual stocks. No recession is in sight, and all portfolios remain fully invested.
U.S. nonfarm payrolls rose 213,000 in June. May payroll numbers were revised up from 223,000 to 244,000, and the April numbers were revised up from 159,000 to 175,000. Wage inflation rose 2.7% in June compared to a year ago. These Goldilocks numbers will one day come to an end, but not today.
The unemployment rate increased from 3.8% to 4.0%. The broadest measure of unemployment, U-6, rose from 7.6% to 7.8%. In our opinion, the increase in these two unemployment numbers represents optimism by some people who had endured years without hope. Now, in this bubbling economy, they’re feeling encouraged to seek employment but are classified as “unemployed” until they find their next job.
The U.S. economy grew at the fastest pace in nearly four years this spring. This reflects the broad-based momentum that suggests the second-longest expansion on record isn’t yet running out of steam. The first estimate of 2nd Qtr GDP rose a very nice 4.1%. This is a “real” number, meaning after inflation. First-quarter GDP was revised upwards from 2% to 2.2%. First-quarter GDP numbers have consistently been a lower number than the rest of the year for a long time. Overall, 2015 had 2% growth, and 2016 had 1.9% growth. Lorenz Financial now believes it is safe to say, “Our mediocre economy with only 2% annual growth is over.” It will be safer to say this six months from now, assuming our “plus 3%” growth continues.
The S&P Case-Shiller national home price index posted a 6.4% annual gain in May – the same as the previous month. The 20-city composite recorded a 6.5% gain year over year, down from a 6.7% annual gain last month.
Some tech stocks have been hammered lately.
From July 24 to July 30, 2018, Facebook stock dropped from a high of $218.62 to a low of $166.56 per share. This is a 23.8%. drop, primarily on July 26. See the chart above.
Do you own Facebook as an individual stock? If you do, this is called taking an asymmetrical risk or single stock risk. Because there are buyers and sellers of every individual stock in the marketplace that know and understand that stock better than you or Mark does, we’re both at a distinct disadvantage and therefore taking added and unnecessary risk when we buy individual stocks. Lorenz Financial does not buy individual stocks for clients. We buy highly diversified, low-cost, and tax-efficient mutual funds and exchanged traded funds.
Don’t let an individual stock burn you! The key to minimizing single stock risk is to have a significantly diversified portfolio. If you don’t know how to do that, call Mark at Lorenz Financial.
Where might the stock market be headed over the next 10 years?
Lorenz Financial believes in the theory of “Mean Reversion.” Mean Reversion suggests asset prices must eventually return back to their long-running mean of the entire database.
For example, since the S&P 500 Index has returned approximately 10% per year since 1928 (Investopedia), if recent returns have exceeded 10% for some time, then at some point returns will drop below 10% for a near equal amount of time to maintain the long-term average of 10%.
Since S&P 500 returns from 2009 to 2017 have been 15.6%, the likelihood of lower returns over the next 10 years are significantly increasing. Lorenz Financial suggests the following for equities over the next 10 years, assuming a 2% annual inflation rate:
U.S. Equities: 5.0% to 7.0% average returns per year
International Equities: 7.5% to 9.5% average returns per year
A well-diversified, stock-only portfolio: 6.0% to 8.0% average returns per year
Of course, bonds and cash will have a lower return. Therefore, a well-diversified portfolio that includes U.S. equities, international equities, U.S. bonds, and cash will have a lower average annual return of perhaps 4 to 6.5% per year, depending on a client’s risk tolerance and portfolio construction.
Are you disappointed with these numbers? Well, the only prudent course of action is to spend less and save more.
Wells Fargo Update
I know everyone is getting tired of hearing bad news coming out of Wells Fargo, but it just keeps coming! The news this time is Wells Fargo financial advisors pushed clients into products that generated additional fees and often moved client assets into higher-risk products to generate higher revenue for the bank and bigger bonuses for the advisors. Wells Fargo advisors often targeted wealthy clients in their Private Bank, sometimes steering them into alternative investment products in which Wells Fargo was the majority owner – allowing the San Francisco bank to collect another helping of fees. In Lorenz Financial’s opinion, “alternative investment products mean investments that are hard to understand, with high volatility, high fees, and very likely low returns.”
Wells Fargo managers often mandated quotas for their advisors to put clients into these alternative investment products such as private equity or hedge funds, regardless of whether these investments were appropriate for the investor. What?!?!
August 1 News Flash – Wells Fargo has been fined $2.09B as a penalty for alleged misrepresentation of mortgage loan quality during the 2008 financial crisis.
Hey Attorney General Jeff Sessions, why aren’t the top 100 past and present managers and directors of Wells Fargo in jail?
Recommended Action for Your Stock Portfolio
We’re raising our 2018 S&P 500 operating earnings estimate to $155. 2019 operating earnings are also increased to $170. With our estimated PE ratio range of 17 to 18, as investors begin to look towards 2019 results, the S&P 500 Index has the potential to trade into the 3,000s (170 X 18 = 3,060).
Based on the research performed by Lorenz Financial, the very short term, from now until year-end, is unpredictable as all short-term moves in the stock market are unknown. But history has demonstrated a tendency for a market pull-back in the late summer and autumn of off-presidential election years. No guarantees – it might happen, or it might not. Any downturn, though, will most likely be short-lived and less than a 20% drop.
After the midterm elections, investors will focus on 2019 corporate earnings, which are increasing due to very nice GDP growth and lower taxes. The stock market could reach the area of a significant top during the calendar year 2019.
But during 2020 and beyond, sooner or later we will have another recession and a bear market – it’s beyond the horizon, and we can’t yet see when it will be coming. When the recession is upon us, Lorenz Financial fully expects a bear market with at least a 20% downturn from the previous market high.
Today, all portfolios remain fully invested. A buy signal might develop. If this happens, Lorenz Financial will make a quick announcement. Until then, our recommendation for new stock market money is to dollar cost average every pay period.
Lorenz Financial is watching two things to help predict the next recession and bear market: An inverted yield curve and a downturn in the Conference Board Leading Economic Indicators (LEI). Both are strong indicators that have predicted a near-term recession in the past.
The U.S. economy grew at a real rate of 4.1% in the second quarter. If GDP grows too fast, inflation could increase and drive short-term interest rates higher than long-term interest rates. If this happens, the phenomenon called an inverted yield curve might develop. Today we do not have an inverted yield curve – no danger sign yet.
In June, the LEI advanced another 0.5%, bringing the gain over the last six months to 2.5%. The gains are widespread with eight of the 10 components showing gains. No danger sign yet from the LEI.
Jumping from stocks to bond, the bear market in bonds continues. Investors should definitely not hold any long-term bonds or long-term bond funds. Long-term is defined as a “duration” that’s greater than seven years.
The Federal Reserve took no action on interest rates at the August 1 conclusion of their recent meeting, but they indicated they’re still on track to raise short-term rates at their September and December meetings this year. Quantitative tightening continues by the Fed, with $40B in U.S. Treasuries being sold off each month during the 3rd quarter. This increases to $50B in the 4th quarter. This action will slowly increase long-term interest rates, which will decrease the price of existing long-term bonds.
The total U.S. deficit is estimated to exceed $22 trillion during 2019. This cloud is only getting bigger and darker.
The PCE inflation index rose 2.2% year over year in June. The core index, excluding food and energy, rose 1.9% year over year in June. Both numbers were unchanged from the previous month.
Long-term inflation expectations can be determined by calculating the difference between Treasury bond yields and TIPS real yields. Results are shown below:
Treasury Bond Inflation
5 Year 2.00%
10 Year 2.12%
30 Year 2.14%
Recommended Action for Your Bond Portfolio
Our bond market investments remain unchanged. We are investing only in short-term, investment-grade bond funds; intermediate-term, investment-grade bond funds; and short-term, high-yield bond funds.
We’re not recommending any long-term bonds or long-term bond funds due to the current high interest-rate risk. Muni bond funds are not recommended at this time due to the risk of too many U.S. cities and states going bankrupt from unfunded pension obligations. Treasury bond funds and international bond funds are not recommended at this time due to their low yield. Bond funds that invest in emerging markets are a very high risk due to the recent strength of the U.S. dollar, low yields and the risk of bankruptcy.