Is North Korea the Next Big Threat to Your Portfolio?
Dear Valued Clients and Friends,
This week’s Dividend Café is as devoted to summarizing and analyzing market action from the first half of 2017 as could be expected, but there are some topical intrusions that warrant attention – namely, this mad man in North Korea and what their perpetual nuisances represent in terms of geopolitical (and therefore, market) implications. It’s shorter than last week’s but filled with practical takeaways, so dive on in …
First Half of 2017
So the Dow and S&P 500 returned a little over 8% for the first half of 2017, leaving bears shaking their heads and also leaving perma-bears totally set to call a major correction for the 25th time out of the last three corrections … In 2016 the story was “U.S. risk assets are much more attractive than any other alternative” – but in 2017 (so far), the story has been “risk assets look good as we bet on a global reflation.” It has not just been U.S. stocks and credit that have performed, but international markets as well, with emerging markets doubling the return of U.S. equities year-to-date. Returns in the U.S. have not been monolithic, with certain sectors and names accounting for a large part of the return, and the dispersion amongst sectors and individual stocks being quite high. Tech and Health Care are the top two winners YTD, with Energy and Telecom the detractors. Industrials, Materials, and Utilities were the only sectors that they themselves performed within 1% of what the S&P 500 itself did …
The 10-year bond yield started the year at 2.5%, came to 2.15% just a week before June ended, but saw bonds sell off big last week to end the second quarter at 2.3% (a huge move in a week). So duration oriented bonds had a positive return in the first half of 2017, but gave up a lot of price “gains” in the last few days.
The dollar was down YTD against the Euro and Sterling Pound and Yen, in what was the genesis of so much consensus that Wall Street analysis has been so wrong so far this year.
Please tell me Dennis Rodman is not involved in my portfolio
There is no question that the foreign policy nuisance that Kim Jong Un and the North Korean dictatorship represent has intensified in the past few months, this week’s ICBM test launch being the latest escalation. The market belief about North Korea has mirrored the State Department belief about North Korea for over fifty years, both in hindsight proving to be accurate: That is, they have been a rogue regime, brutal to their own people, but manageable by basically paying them off whenever they get out of line. It is a foreign policy that has not allowed for much escalation, but has allowed this regime (formerly Kim Jong Il and now his son, Kim Jong Un) to continue poking around at South Korea and other Asian neighbors and violating most conventions and lines set on them. Markets have not responded to Kim Jong Un’s provocations because markets have always believed (and have thus far always been right) that they are going nowhere, and one way or the other the animal will get put back in its cage.
The recent escalation increases concern about a new level of drama in this saga. A military strike by the U.S. on North Korea risks a retaliatory strike against Asian allies that could be catastrophic. Diplomatic talks seem futile. Therefore, the most likely play is that the U.S. continues to pressure China and Japan and other trading partners to economically squeeze North Korea into submission. We do not see a scenario where the west is going to allow North Korea to develop and maintain actual nuclear capability, but we still agree with the markets that U.S. military intervention is still a very last resort, and that the drama will get played out with the U.S. and China. Getting China to be our partner in economically squeezing North Korea into submission will not be easy, and will require a very artful deal.
Has the time come to travel overseas?
The first half of 2017 saw strong market returns in the U.S., in Europe, in Japan, and in emerging markets. The valuations remain lowest in emerging markets, then Europe/Japan, and then the U.S. So if the U.S. is the most expensive stock market on a valuation basis, doesn’t that mean it is time to overweight other regions and underweight the U.S.? That thinking is overly simplistic for a variety of reasons, and requires a basic understanding of what we are buying when we buy stock markets to be able to answer. We are buying a discounted flow of future earnings and dividends. There are a whole lot of reasons in the short term that valuations may fluctuate around their average, from interest rates, to inflation expectations, to macroeconomic conditions, to geopolitical context, etc. And there is absolutely no way to monetize opinions about valuation in any short term context (if one believes Europe is cheaper than the U.S. now, they must REALLY have thought it was cheaper than the U.S. four years ago, and yet the U.S. return has more than doubled the European market returns in that time period). The reality is that valuations and valuation analyses cannot trump long-term allocation decisions rooted in risk/reward trade-off. Yes, multiples are lower in certain international markets than the U.S., and yes, that may mean for a higher expected return in some markets long term. But, risk levels (expected volatility) also remain real, and vary from market to market for a reason. Our job is to manage the return needs of our clients, and do so within volatility parameters. We make tactical tilts where we feel warranted (primarily around rebalancing moves to capture more shares of under-performing asset classes), but the idea that macro fears in Europe should be ignored because their P/E is lower than the S&P 500 is not just simplistic, it is silly.
The elusive correction that buyers would love
If I gave out candy for every time a client has said to me over the last five years, “shouldn’t we lay low now that markets are so high?”, it would look like Halloween. Attempts to time the inevitable correction have been catastrophic for those who have delved into that act of futility, though fortunately this describes other investors, not our clients (we refuse to entertain attempts to do what cannot be done; in fact, the 80%+ of the times we have severed a client relationship it has been because of something along these lines). The reality is that as a long-term accumulator of stocks on behalf of my own portfolio and that of my clients, there is nothing I would like more than a summer correction. A 5-10% drop in stocks would give me cheaper purchase levels, and therefore higher long term expected rates of return. Even those with no additional funds to invest benefit from corrections due to the reinvestment of dividends that takes place at lower price levels. The arguments for a correction, which have certainly been on the table for quite some time and proven very elusive thus far, are that tech stocks are tired, Washington DC is dysfunctional, and central banks are tightening or threatening to tighten. The reasons a correction could very well be delayed longer are that earnings are rock solid, global economies are seemingly improving, and credit markets are extremely liquid and accessible. For those worried about a correction, I do not say “have no fear – it will not happen.” Rather, I say, “have no fear, eventually it will happen; but don’t be a casualty of market frivolity sitting around waiting.” Expect it and enjoy it, but don’t time it, because you can’t.
Will the kryptonite for FANG stocks be different than we all thought?
“FANG” is a lazy way to talk about the “big tech” stocks that dominated in 2015 and have done well again in 2017, but had a lousy 2016 (Facebook, Amazon, Netflix, Google). I have spoken and written at length about the valuation challenges that exist with these names (namely, they are very expensive), and the historical realities that buying the hottest dot after a couple years of torrid growth has often meant sustained under-performance as valuations revert to reality. But what if the issue with some of these types of stocks will prove to be different than mere “valuation”? The financials and energy sector have been preferred targets for the left, populists, and the media for years. The hip and cool tech sector has largely gone unscathed from any political controversy, cultural clash, or external anxiety. What if these FANG stocks (and their many cousins) become the target of regulators, politicians, and even the culture at-large? Uninvited scrutiny, whether fair or unfair, has a way of raining on the parade of valuations … This is a theme I am seeing come up in more and more analyst reports, and it bears watching.
India as a model for, well, lots of countries
Prime Minister Modi of India has done more to modernize the Indian economy the last few years than probably any other effort combined for thousands of years. They are attracting foreign capital to their debt market. Their equity market is on fire. And they have now launched a “Goods & Services Tax” which vastly improves upon the complexity of the prior system which was ripe for corruption and inadequate collection. They are still in need of improved capital formation and there is bad debt to deal with in the private sector (though dealing with it as they are is better for markets than ignoring it or hiding it). They have a central bank with policy flexibility (unlike most central banks on the planet). Should private investment be provoked as is the intention of policymakers, India may be a worldwide story for decades to come.
What about tax reform???
We are on record as saying that we do believe tax reform will get done, likely in Q1 of 2018. But that broad forecast does not say a lot about the specifics. We mentioned last week the idea that is floating around to extend period that a tax bill can pass through reconciliation despite not being deficit-neutral to 20 years, and that would be a game-changer, but assuming that does not happen, we expect it will be called “deficit neutral,” and will use dynamic scoring to offset $500 billion or more of the “lost revenue” (i.e. tax cuts mean lower revenue, but lower rates mean more growth which means more revenue even though at a lower rate … think: Laffer’s Curve). The issue is not, by the way, whether or not the tax changes really do create $500 billion of offset via better growth (we think it could be MORE than that; many believe it will be nowhere near that much; rather, the issue is how it passes procedurally). We do not believe the corporate tax rate will make it all the way down to 15%, but we are still hopeful for 20%. The repatriation on overseas profits, full expensing for capital expenditures, and territorial tax system will all be part of the reform package, in our opinion, and are all very pro-growth. Expect many deductions and loopholes to be eliminated. No one has made a killing predicting political tea leaves lately, but this remains our reasonable and deeply analyzed expectation.
No collusion here
The only stock markets around the world in negative territory for the first half of 2017: The worst performer was Russia (-13%). Israel was down a modest 3% as well. It was hard to find a global equity index that did not do well in the first half of 2017.
What I am reading
A long-time client recently asked me to include what books I have been reading, outside of my standard weekly investment research (the volume of which you wouldn’t believe if I told you). I’ll try to include a little snippet of monthly book reads the last issue of each month for those interested. From late May into the end of June the book reading included:
- Fall from Grace: The Untold Story of Michael Milken – going back into May I had begun a massive book project on the 1980’s investment legend, Michael Milken. This book was one of five books I read the last three months on the famous bond trader and his utterly inexcusable prosecution. I believe there are extraordinary lessons about Milken’s innovations within capital markets and I believe there was society-changing precedent set in this case at the hands of abusive prosecutors. I am not done with my study here.
- Shoedog: A Memoir by the Creator of Nike – Phil Knight’s masterful story of the first 15 years of Nike (from its embryonic stages as a licensing deal with a Japanese manufacturer, to it’s 1980 IPO), is a practical economics textbook, not only providing a gripping account of Nike’s struggles to manage capital structure, liquidity, and cash flow in its first decade or so of existence, but also a classic defense for free trade and the benefits of economic globalization. No one who understands Nike’s story can fail to appreciate the wonders of a global supply chain, and how the wealth pie is expanded when labor and product sales are pollinated across the globe.
- A Man and His Presidents: The Political Odyssey of William F. Buckley Jr. – you won’t find a credible or serious book about the 20th century intellectual lion, Bill Buckley, that I haven’t read (or won’t read). Besides being an heir of Bill Buckley’s ideological legacy, I also happen to serve as a trustee at his National Review Institute, and books on Buckley scratch both my political and historical itches. This particular book traced the relationship Buckley had with a generation of different Presidents.
- The Man who Knew: The Life and Times of Alan Greenspan – Sebastian Mallaby is one of my favorite writers, even though I disagree with him on plenty. He wrote a masterful post-crisis book on the place of hedge funds in righting the wrong of the financial crisis. His 700-page biography on Fed “maestro,” Alan Greenspan, was a wonderful book on a very layered character in American economic history.
- Inside Out – An Insider’s Account of Wall Street – Dennis Levine’s gripping tale from his own pen; 400 pages of 1980’s M&A drama turned into inside trading scandal turned into personal redemption. Levine’s arrest was a watershed moment in 1980’s finance; his book was a “can’t put down” delight
- For God and Profit: How Banking and Finance Can Serve the Common Good – perhaps the most prominent natural law intellectual alive today, Dr. Gregg’s doctoral studies at Oxford were in the field of moral philosophy, and he takes a philosopher’s acumen to the world of economics in this extremely important, readable, and vital book
Chart of the Week
Past performance is no guarantee of future results. This is not a disclaimer – this is me actually saying it, because it is true. With that said, an interesting historical view on how the second half of a calendar year does when the first half of a calendar year has performed like it has this year:
Quote of the Week
The real trouble with this world of ours is not that it is an unreasonable world, nor even that it is a reasonable one. The commonest kind of trouble is that it is nearly reasonable, but not quite. Life is not an illogicality; yet it is a trap for logicians. It looks just a little more mathematical and regular than it is; its exactitude is obvious, but its inexactitude is hidden; its wildness lies in wait.
– G.K. Chesterton
Originally published on The Dividend Café.
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