Welcome to the September newsletter! Today, we’ll update you on the Federal Reserve and Treasury, the latest on the deceleration of economic growth, recommended actions for your stock and bond portfolios, and more. Let’s get started!
Summary
The pace of economic growth is decelerating due to the ongoing trade war with China and the global growth slowdown. Most of the real-time economic data we monitor remains weak, with the U.S. manufacturing sector in contraction. But most importantly a recession is not going to begin in 2019. All portfolios remain fully invested.
Employees should continue to make their weekly or monthly contributions to their employer’s retirement plan or IRAs. Additional money can be added to investors’ stock market allocation, but only on a dollar-cost-average basis.
The Economy
Employment
U.S. nonfarm payrolls rose in July by 164,000, which was slightly higher than expected. The June payroll number of 224,000 was revised down to 193,000, and the May payroll number of 72,000 was revised down to 62,000. The rolling three-month payroll average decreased from 170,000 last month to the current figure of 140,000.
Unemployment was unchanged at 3.7%. The Labor Department refers to this metric as U-3. U-6 is “total unemployed, plus all persons marginally attached to the labor force, plus total employed part-time who want a full-time job.” U-6 has dropped from 7.5% in July 2018 to 7.0% in July 2019. 7.0% is almost a record low.
Gross Domestic Product
The U.S. economy grew at an annual rate of 2.0% after inflation in the second quarter of 2019. This is the Bureau’s second estimate of the second quarter; the first estimate was 2.1%. This quarter’s GDP reflects positive contributions from personal consumption expenditures and federal, state, and local government spending.
Inflation
Annual inflation rose slightly in July from 1.3% to 1.4% as measured by the Personal Consumption Expenditures (PCE) price index. The core PCE index, which excludes food and energy, did not change from 1.6% last month. All numbers represent changes from the same month one year ago.
Long-term inflation expectations can be determined by calculating the differences between Treasury bond yields & TIPS real yields of the same maturities. Results are:
| Bond Maturities | Annual Inflation Expectations |
| 5 Year | 1.35% |
| 10 Year | 1.55% |
| 30 Year | 1.61% |
Inflation numbers above have dropped 0.20% in the past month.
Stock Market
Commentary
Based on economic fundamentals, the U.S. economy has the potential to maintain an annual real GDP growth trajectory close to its 10-year average of 2.2%. Therefore, we believe this 10.5-year bull market remains intact. Hers’s why:
Inflation is fluctuating very little and is neither too high nor too low. Based on 2019 S&P 500 Index operating earnings of $167, the market PE ratio is 17.4 (2,906 / $167 earnings as of the Sept 3 close).
As you’ll see below, the yield curve is inverted. But a much more reliable indicator of a pending recession and bear market is the LEI, and it reached another new high in July. Another recession is in our future at some point, but not in the near future. Overall, our stock market outlook remains positive.
Will the following two leading indicators predict the next bear market?
1. The U.S. Treasury Yield Curve as of August 30 is below.
This is the most inverted the U.S. Treasury yield curve has become during this economic cycle. Using the 3-month Treasury as a starting point at 1.99% and looking to the right, ALL of the longer-term maturities have a lower yield. This is not terrible as the world is enduring over $17 trillion dollars of sovereign debt with a negative yield. Countries with negative-yielding debt include Switzerland, Germany, France, Japan, Denmark, Netherlands, and Austria. These negative yields are forcing many international buyers to bring their safe money to the U.S. and buy Treasuries. This high demand is driving Treasuries prices higher and their yields lower.
Conclusion: The U.S. Treasury yield curve is giving a recessionary signal, but its meaning is in doubt, with foreign investors buying large quantities of U.S. Treasuries and driving longer-term bonds to unrealistic low yields. The U.S. Treasury yield curve inversion has increased the possibility of a recession beginning in the next year or two.
2. The Conference Board said the Leading Economic Index (LEI) increased in July 0.5%, and the June decline previously reported to be 0.3% was revised to have declined only 0.1%.
These are good numbers. The LEI spokesperson said, “While the LEI suggests the U.S. economy will continue to expand in the second half of 2019, it is likely to do so at a moderate rate.”
Conclusion: The LEI is suggesting the economic expansion that began in 2009 is continuing. Over the past 60 years, the LEI has fallen ahead of each recession, and the July reading was a new cycle high.
Stock Market Valuation
We estimate the 2019 S&P 500 Index operating earnings will be $167. Our preliminary 2020 estimate is $175. Based on our price/earnings ratio range estimate of 17 to 18 times operating earnings, we are increasing our S&P 500 Index target range to be in the 3,100s (175 x 18 = 3,150).
This stock market valuation takes into consideration our outlook for low inflation and the highly accommodative monetary policy now in place at the Federal Reserve and at least a partial resolution of the trade war with China.
Recommended Action for Your Stock Portfolio
We regard the risk of a recession as low. Our two key pre-recession indicators continue to suggest the economy will continue on a slower, but positive growth track in 2019. Therefore, we recommend investors’ stock market allocation should be fully invested in a low-cost, highly diversified, and tax-efficient portfolio. Additional money can be added to the stock market, but only on a dollar-cost-average basis.
A PIMCO Story
A subscriber to this newsletter tells the following story. One of his bond mutual funds is managed by the Pacific Investment Management Company (PIMCO). Normally, this particular bond fund has a stable price. But earlier in August, the fund dropped 0.5% in one day. Being inquisitive, our investor friend called PIMCO and asked, “Did the fund drop because there was a distribution or did some of the underlying securities in the fund decrease in value?” The answer was unbelievable: “You will have to ask your advisor.”
Our friend said, “But I don’t have an advisor, I manage my own portfolio.” The answer was the same. He asked two more times and every time he was told, “You have to ask your advisor.” This response was totally insulting! Our friend sold 100% of his PIMCO bond fund the next day.
The absurdity of some companies who provide only a ludicrous level of customer service amazes us. The sooner these companies go out of business, the better.
We have never owned a PIMCO bond fund in our family’s account. Lorenz Financial has never purchased for a client a PIMCO mutual fund and never will.
What does it take for an investor to manage his or her own portfolio?
Here’s how to successfully manage your own portfolio:
- Use courage and patience to be a long-term investor.
- Have a written plan.
- At a minimum, be knowledgeable about the stock and bond markets.
- Have the time and desire to manage your own portfolio.
Every investor should have a portfolio that:
- Is highly diversified
- Contains low-cost products
- Has low advisor’s fees (for those who hire an advisor)
- Has tax-efficient brokerage accounts
Now construct a portfolio that gives serious consideration to your:
- Needs and objectives
- Risk tolerance
- Liquidity requirements
- Timeframe (when the money needs to be available)
- Tax status
If you can do the above, then you’re ready to manage your own portfolio. If not, please do not seek out advice from a stockbroker or insurance agent. Go to a Registered Investment Advisor who is a fiduciary, and who will always put your interests first.
Bond Market
Commentary
The pace of economic growth in the U.S. has decelerated from 3.1% in the first quarter to 2.0% in the second quarter this year. The Atlanta Fed is predicting the 3rd quarter GDP will come in at 2.0%, and the New York Fed is predicting 1.8%.
We have no prediction when the next recession will hit the U.S. economy, but when it does, interest rates will go down. As interest rates decrease, investment-grade bonds will appreciate in price while junk bond prices will depreciate. If an investor wants to reduce the risk in his or her portfolio, do not sell stocks just to buy junk or high-yield bonds. Instead, to decrease risk in a stock portfolio, buy investment-grade, short-term, or intermediate-term bond mutual funds.
Federal Reserve
The Federal Open Market Committee (FOMC) is scheduled to meet next on September 17 and 18, 2019. We’re expecting the Fed to cut the Federal Funds rate by 25 basis points at that meeting to the range of 1.75% to 2.0%. At the annual Fed Conference in Jackson Hole in August, Chairman Powell pointed out that only Congress and the Administration has authority over trade policy. He also said the Federal Reserve has no tools to avert the damage of a trade war.
U.S. Treasuries
Secretary Mnuchin said the Treasury is “very seriously considering” issuing new ultra-long-term U.S. Treasury bonds. This could include new securities with maturities ranging from 50 to 100 years. We would like to see fewer short-term Treasury bills and notes offered for sale (with less supply, their prices will go up and yields down) and more Treasury long-term bonds offered for sale (with more supply, their prices will go down and yields up). This would create a more normally shaped yield curve.
Recommended Action for Your Bond Portfolio
Our bond market recommendations have not changed since last month. We are recommending bond investors only participate in the following types of bond mutual funds or bond ETFs:
- Short-term, investment-grade U.S. bond funds
- Intermediate-term, investment-grade U.S. bond funds
- Very short-term, high-yield U.S. bond funds
- Ginnie Mae bond funds
- Conservatively allocated U.S. balanced funds with 30-50% in stocks, the rest in bonds
PAST PERFORMANCE IS NO GUARANTEE OF FUTURE RESULTS.