When minutes from the September meeting of the Federal Reserve were released this week, traders received confirmation that the Fed is likely to continue raising interest rates.

Officials voted unanimously at their meeting to raise their benchmark rate to a range between 2% and 2.25%. Projections released after the meeting show most officials expected they would need to raise rates one more time this year and around three times in 2019.

In the long run, Fed officials indicated that they expect the rate to be between 2.75% to 3%. That would be well below the rates seen before the financial crisis in 2008.

Source: Federal Reserve

Long term rates are also below average. The 10-year Treasury was recently yielding 3.19%, up from about 2.4% at the end of last year. But it’s still well below its average nominal yield of 6.05% since 1958, according to JPMorgan

Higher rates, as the Fed expects, are based on the assumption that the economy performs in line with current forecasts. According to The Wall Street Journal,

“Federal Reserve officials signaled they see a strong economy justifying continued interest-rate increases—and said they will watch for evidence their moves are keeping economic growth on an even keel, minutes of their September policy meeting showed.

The central bank this year has grown increasingly determined to gradually lift rates to such a neutral setting because the unemployment rate is below officials’ estimates of the level consistent with stable inflation and the economy is expanding solidly.

The minutes show little consensus so far about what to do after they determine rates have reached neutral.”

What’s Next for the Fed

Many participants at the meeting said future changes in interest rates would be guided more by “the evaluation of incoming information and its implications for the economic outlook,” the minutes said.

“Estimates of the neutral federal funds rate would be only one among many factors that the committee would consider in making its policy decisions.”

New York Fed President John Williams, who has conducted leading research to estimate the real neutral rate of interest, has joined Fed Chairman Jerome Powell in downplaying policy makers’ ability to pinpoint such estimates.

Earlier this year, Mr. Williams said such estimates were shining brightly in guiding policy makers, but last month he said that now rates are closer to such a setting, “what appeared to be a bright point of light is really a fuzzy blur.”

But, not everyone agrees rates should be higher. “The Fed’s rate increases became the center of attention at the White House and on Wall Street after stronger economic data this month prompted investors to take more seriously the central bank’s telegraphed plans to steadily lift rates higher.

President Trump blamed the Fed for the subsequent market selloff and described the central bank as “crazy” and “out of control.”

Before Mr. Trump, U.S. presidents hadn’t commented publicly on monetary policy in more than 25 years. Mr. Powell and other Fed officials have said they will not be influenced by political pressure, and the minutes didn’t mention Mr. Trump’s comments made prior to the meeting.”

This creates uncertainty for investors. And, uncertainty has weighed on returns.

Returns Are Another Concern for Investors

As rates increased, investors have suffered. The Bloomberg Barclays 10-year U.S. Treasury Bellwethers index has returned -3.73% year to date through Sept. 30, and the 30-year index was off by 6.55%, according to JPMorgan Asset Management.

Also underwater over that stretch are corporate bonds, mortgage-backed securities, and municipal bonds—down 2.33%, 1.07%, and 0.66%, respectively.

Even the relatively well-performing ProShares S&P 500 Dividend Aristocrats exchange-traded fund (NYSE: NOBL) has returned just 6.5% this year, trailing the S&P 500’s 10.9%. That ETF tracks S&P 500 companies that have raised their dividend for at least 25 straight years.

NOBL fell in line with the broad stock market last week.

Pros Differ on the Best Approach

Barron’s reviewed the current environment with two well known and highly respected fixed income fund managers.

Dan Fuss, co-manager of the Loomis Sayles Bondfund (LSBRX), said “Interest rates are rising. That, more than anything else, is the most important thing right now.”

“Concerned about rising rates, Fuss has positioned the $12.1 billion fund more defensively by adding a lot of holdings with shorter maturities. Shorter-dated credits help to buffer the impact of rising rates, as bonds with longer maturities will make more payments than shorter-term holdings.”

In theory, the present value of those future cash flows can take a big hit when rates rise. Fuss has also put more emphasis on higher-quality issues.

If rates were to rise another percentage point in a short time, longer-dated Treasuries “will probably outperform long corporates, but they will still get whacked 7%, 8%, 9%, 10%” in price, says Fuss. “That’s not good.”

He also has increased the percentage of highly liquid holdings, including Treasury bills, to about 35% of the portfolio.

“We are waiting for rates to go higher and spreads to widen out,” he says. “We are just much more conservative.”

Barron’s also spoke with Clyde McGregor, who co-manages the Oakmark Equity & Income fund (OAKBX). Oakmark’s returns are higher in the long run because of its exposure to stocks.

Source: Barron’s

Oakmark’s McGregor has a value investing framework focused on “how something is priced,” he notes.

“Income has been overpriced” and “we have been defensive for quite some time, relative to duration risk,” referring to the risk bonds face when interest rates spike.

As of June 30, Oakmark Equity & Income had about 55% of its holdings in U.S. stocks and another 6% in non-U.S equities, according to Morningstar. Another 23% was in bonds, though only a tiny sliver of those holdings were in credits with maturities of more than 10 years.

The fund’s largest stockholdings included General Motors (NYSE: GM), Bank of America (NYSE: BAC), TE Connectivity (NYSE: TEL), and Mastercard (NYSE: MA). Their respective yields were recently 4.5%, 2%, 2%, and 0.4%.”

Income investors might find any of those stocks to be appealing, or they could allow Fuss or McGregor to navigate the environment for them.

 

Investors have a simple goal. They want to make money. They can do this by finding stocks that go up and avoiding stocks that go down. Of course, they can also avoid investing in the overall market when the stock market is weak.

Financial writers also have a simple goal. They want to write great headlines. And, headlines will at times be sensational rather than useful. That’s why it is important to read the story rather than simply skim headlines.

An Important Headline But Not the Full Story

Discount broker Charles Schwab has been highlighting an important story on its web site. The headline is “When Markets Dip, Don’t Drop Out” and the story includes data showing the importance of not selling into a bear market.

In summary, the article uses data to show that it is best for investors to hold on to their investments during a bear market.

Data is used to compare three possible scenarios. Marketwatch summarizes the three scenarios:

“There is the stalwart, who stayed the course on his investments no matter what; the reactor who pulled out money in 2008 and stayed out (depicted in red) and the waffler (blue), who moved money out after any downbeat year. The latter two kept saving 10% of their salary.”

The waffler reinvests in the market after two years of gains. The chart shows the stalwart “wins.”

Source: Shwab.com

Now, if you had 40 years and started investing in 1978, this was certainly the best strategy. But, what if the circumstances are slightly different?

Not All Time Frames Are the Same as That Example

Examples like this often use a 40 year holding period because that is often assumed to be the time of a typical working career with contributions to a retirement plan. But, investors won’t always have 40 years to wait for their funds to recover.

Even if they do have long time frames to wait for a recovery, they may not have as much time as is truly needed. The next charts shows the Dow Jones Industrial Average which took more than 25 years to recover from the 1929 crash.

Now, times were certainly different back then. But, stock prices did move sideways for 16 years beginning in 1966.  And, prices took more than 12 years to recover from the decline that followed the 2000 peak in prices.

And, then there is the example of stocks in Japan.

This is a chart of the Nikkei 225, a benchmark index of the broad stock market in that country. The Nikkei remains more than 40% below its all time peak which was reached in 1989. Nearly 30 years after peaking, the buy and hold investor still shows a significant loss.

Retirement Needs Could Drive Decisions

In the extreme case, let’s consider an investor in Japan who retired in 1989. That investor suffered a bear market in stocks and the problems of low interest rates. That is also an important factor to consider.

In the past ten years, rates have been low in the United States. In Japan, interest rates on ten year Treasuries fell below 2% in 1997.

Source: Federal Reserve

Of course, this is all unprecedented. But, investors, especially those nearing retirement should always expect the unprecedented. One of the worst mistakes investors in that situation could make could be to expect the future to be just like the past or even more favorable than the past.

While Schwab makes light of the idea, the market timer that they label the waffler didn’t fare poorly. This individual could probably have enjoyed a comfortable retirement. In other words, there is no need to get every single possible dollar out of the stock market. Avoiding risks could be equally important.

Japan, it can be argued, is a special case. The country has seen its economy slow as the population ages. But, other countries could face a similar scenario and in fact economies have been slowing all around the world and populations are aging all around the world.

Perhaps, Japan should not be considered a special case but could be considered as one of the possible scenarios long term investors face. In doing that, investors are being realistic. And it is important to be realistic when considering retirement.

The Right Answer Depends on Personal Circumstances

So, is buy and hold always the best solution for an investor? Certainly not. Just because it was for the 40 years beginning in 1978 tells us nothing us about what to expect in the next 40 years and it tells us even less about what to expect in the next five years or even one year.

An investor’s personal circumstances should always be the primary input into the decision process. If you are retiring soon, is risk possible to accept? If so, stocks should be considered. If not, three month Treasuries as used in the Schwab model could be best.

But, even of short term Treasuries are best, are they realistic? They offer little in the way of returns and many retirees may need income. This could push them back to stocks.

Now, shorter term models could be useful to consider, such as a 200 day moving average (MA) or a 10 month MA. These models would meet the objectives of the waffler in the Schwab model but would get back into stocks quicker than the two year requirement shown in that model.

It almost seems like the two year timeframe was selected to keep returns low. Stock prices tend to rise rapidly in the two years after the bear market ends and this model was specifically designed to exclude that time frame.

A better and more timely could meet the investor’s true objective of reducing risk consistent with attaining high returns. In the end, the amount of risk must be considered and that will be based on personal circumstances.

It could be best to move to cash and miss part of the gains of a buy and hold investor, especially if meeting a financial milestone like retirement is the objective of the investor. That must be remembered, no matter what the headline says.

 

 

 

Interest rates can cause stock market crashes and they can also contribute to extended bear markets in stocks. The problem for equity investors is that higher interest rates can pull money away from the stock market.

Imagine, and this is purely a hypothetical in the current market environment, if ten year Treasury notes yielded 10%. Investors would have a choice between risk free rates of 10% and a risky investment that would deliver variable rates of return. Many would invest in the Treasuries.

That scenario wasn’t always hypothetical. The chart below shows interest rates on the ten year and demonstrates that there was a time when Treasuries were a meaningful alternative to stocks.

Source: Federal Reserve

Treasuries Are Now Relatively Attractive

While, in hindsight, Treasuries were attractive on an absolute basis in the early 1980s, many investors may find them attractive on a relative basis right now.

In July 2016, the ten year yield dropped below 1.5%. It’s now more than double that level. That means investors could move into fixed income investments because they yield so much more than they did two years ago.

Rates are rising as stocks also become increasingly risky in the eyes of some investors. This makes it important for investors to consider what sectors in the stock market could do better as rates rise.

Analysts note that not all sectors will suffer as rates rise.

“Some areas of the market that look inexpensive—financials, enterprise tech, industrials—actually would benefit from rising interest rates,” contends Savita Subramanian, U.S. equity and quantitative strategist at Bank of America Merrill Lynch.

Of course, not all sectors will do well. Subramanian added, “Utilities, food stocks, and staples are looking relatively expensive, and are much more hurt than helped by a rising interest-rate environment.”

Financials Stocks Could Shine

To understand why financials are sensitive to interest rates, it can help to think of them as retailers. Banks make money by “buying” deposits cheaply and “selling” them at higher prices.

So, higher rates will force them to pay more for deposits, but interest rates on savings accounts and other consumer products tend to rise slower than the rates on loans.

Barron’s notes the average rate on a one-year certificate of deposit, for instance, has climbed from 0.27% to 0.78% since the start of 2016, even as that on a home-equity line of credit has jumped from 4.69% to 6.19%, according to Bankrate.com.

Since the 2008-09 financial crisis, banks have held more cash and low-risk investments on their balance sheets, to comply with regulations. All that cash is essentially dead weight when interest rates are low. But higher rates turn those deposits into income-generating assets.

This indicates financials could be attractive with recent weakness providing a buying opportunity.

Looking at specifics, analysts believe “discount brokers are among the financial outfits with the most sensitivity to higher rates. Charles Schwab (NYSE: SCHW), for example, generated 57% of its revenue from interest income in the second quarter.”

History Shows Higher Rates Could Be Bullish

Despite the fact that rates could affect some sectors in a negative way, overall higher rates could be bullish.

“SunTrust examined 15 periods of rising rates over the past 65 years and found that stocks gained an average of 12.6% during those stretches on an annualized basis, falling only three times.”

A Bank of America analysis found that companies’ price/earnings multiples expanded during half of the recent rising rate cycles and contracted during the other half, indicating that the market is agnostic about changes in rates.

Rising interest rates tend to be destructive under only a few circumstances.

“If rates rise very rapidly or precipitously, the market sees that as disruptive,” says Jonathan Golub, chief U.S. equity strategist at Credit Suisse, noting that sudden spikes can come from unexpected actions by the Federal Reserve, or other “exogenous shocks.”

Higher rates also become destructive above a point at which they start threatening to detract from economic growth. In the past, the magic number was 5%, Golub says. But with the economy growing more gradually these days, the break point is probably closer to 3.5%, he estimates.

Performance Varies Over Time

Sun Trust found that the specific performance of a sector varies from cycle to cycle.

Source: Barron’s

While tech does well at times, investors should be cautious. Analysts worry that tech tends to outperform during periods of rising interest rates, but the stocks’ behavior might be coincidental.

Tech shone as rates jumped between 1998 and 2000, for instance, but the gains came amid a euphoric run that then went bust in epic fashion. This time, the setup for tech’s highflying names also looks shaky, although not nearly as worrisome as it did during the dot-com bubble.

Sectors to Avoid

There is some consensus on sectors to avoid

“Rising rates further darken the picture for home builders. Housing was already unaffordable for some first-home buyers before rates spiked because there are too few low-priced homes available.

Now, ascending rates appear to be dampening enthusiasm even more, as shown by the recent drop in mortgage applications. Add labor shortages and rising materials costs due to the Trump administration tariffs on steel and aluminum and it’s hard to imagine a worse backdrop for the industry.

Auto stocks, which received no love from investors even in better times, are vulnerable to some of the same pressures. U.S. consumers today finance more than 86% of new vehicles and 55% of used ones.

The auto industry hasn’t passed rising rates along to consumers, and manufacturers are still being generous with discounts and incentives. But they might not be able to hold the line for long.”

Data says now is a time for caution. Higher rates will make it more difficult for investors in the equity markets. As rates rise, it could make sense for some investors to move into fixed income investments, locking in higher returns. However, that increases risks associated with inflation.

A nimble approach could be useful, buying stocks and sectors with high relative strength and moving out of stocks and sectors that show a breakdown in relative strength. This strategy could help investors avoid large losses if a bear market unfolds.

 

Tesla CEO Elon Musk is unhappy with short sellers. At least some of his actions seem to be aimed at individuals and fund managers who sold shares of Tesla Motors Inc. (Nasdaq: TSLA) short.

Short selling is defined as “the sale of a security that is not owned by the seller or that the seller has borrowed. Short selling is motivated by the belief that a security’s price will decline, enabling it to be bought back at a lower price to make a profit.”

Investopedia noted, “short selling may be prompted by speculation, or by the desire to hedge the downside risk of a long position in the same security or a related one. Since the risk of loss on a short sale is theoretically infinite, short selling should only be used by experienced traders, who are familiar with the risks.”

Musk recently noted that his opinion of short sellers has changed over the years.

Source: Twitter

The Argument for Short Sellers

Short selling can be used to either generate a profit or to meet the needs of market makers seeking to fill orders from individual and professional investors in stocks.

According to the Financial Times, “Iosco (the international college of securities regulators) says: “Short selling plays an important role in capital markets for a variety of reasons, including more efficient price discovery, mitigating price bubbles, increasing market liquidity, facilitating hedging and other risk management activities.”

The Times noted several reasons for short selling:

“Short selling is really just a way of expressing a view that a particular stock is over-valued, and it appears now that the doubts many short sellers had about the companies they shorted were more than justified.

And it is important there is a powerful incentive for investors to find out what is wrong with individual companies. For example, it was shorters who were the first to work out that something was up with Enron.

Short sellers devote considerable time, effort and resources to establishing the reality behind corporate rhetoric. An enlightened supervisory regime, therefore, would observe their market signals and use them as a sort of early warning system.

Rather than being a source of trouble, the practice actually offers regulators a useful way of anticipating trouble.

Finally, it is the ability to short that creates the classic “hedge” that gave the industry its name. Being able to hedge helps to prevent investors suffering losses during downturns.

Investors in the hedge fund are increasingly institutions such as pension funds (institutional investment now forms a clear majority of all assets managed by the industry). It is surely a good thing that socially valuable investments can be protected in falling markets.”

Musk Disagrees With Short Sellers

Barron’s notes that “Musk has argued that short selling stops companies from going public and motivates shorts to attack “by whatever means possible.”” He seems to believe short sellers are one reason for the volatility in shares of TSLA.

Of course, there are other possible reasons for the volatility in the stock. One reason is simply Musk himself. His comments, especially his tweets, at times create volatility. One example was his announcement on Twitter that he was considering taking Tesla private.

In August, Musk tweeted, “Am considering taking Tesla private at $420. Funding secured” and pushed the stock from $357 to $380.  As it became apparent there was no funding, the stock price fell. And, eventually Musk admitted he had no way to complete the deal.

In September, the Securities and Exchange Commission (SEC) charged Musk with stock fraud, alleging that he knew the statement was false when he tweeted it.

Musk, Tesla, and the SEC were in court on Thursday seeking approval for a settlement in which he and his company agreed to pay $20 million each in civil penalties, to be distributed to investors Musk harmed. Without denying the charges, Musk also agreed to step down as chairman for three years.

It will be some time before we know what Tesla is worth, but shorts are helping drive the price of the stock to its fair value, especially given the fact that Tesla has issued convertible bonds.

Shorting Could Help Markets Function

Market makers often use a strategy known as convertible arbitrage to reduce risk in the convertible bond market.

Barclay’s explains, “…a hedge fund using convertible arbitrage will buy a company’s convertible bonds at the same time as it shorts the company’s stock.”

If the company’s stock price falls, the hedge fund will benefit from its short position; it is also likely that the company’s convertible bonds will decline less than its stock, because they are protected by their value as fixed-income instruments.

On the other hand, if the company’s stock price rises, the hedge fund can convert its convertible bonds into stock and sell that stock at market value, thereby benefiting from its long position, and ideally, compensating for any losses on its short position.

Convertible arbitrage is not without risks. First, it is trickier than it sounds.

Because one generally must hold convertible bonds for a specified amount of time before they can be converted into stock, it is important for the convertible arbitrageur to evaluate the market carefully and determine in advance if market conditions will coincide with the time frame in which conversion is permitted.

Additionally, convertible arbitrageurs can fall victim to unpredictable events.

One example is the market crash of 1987, when many convertible bonds declined more than the stocks into which they were convertible, for various reasons which are not totally understood even today.

A more recent example occurred in 2005, when many arbitrageurs had long positions in General Motors (GM) convertible bonds and short positions in GM stock. They suffered losses when a billionaire investor tried to buy GM stock at the same time its debt was being downgraded by credit-ratings agencies.

So, the market might need traders to take short positions, even if Musk believes they hurt the company. In truth, there is probably nothing that short sellers do to Tesla except distract its CEO from focusing on making cars.

 

 

The Wall Street Journal headline was scary enough even before investors thought about what it could mean.

Mortgage Rates Fast Approaching 5%, a Fresh Blow to Housing Market

The details focused on the housing market. “Mortgage rates hit their highest level in more than seven years this week at nearly 5%, a level that could deter many home buyers and represents another setback for the slumping housing market.

The average rate for a 30-year fixed-rate mortgage rose to 4.9%—the largest weekly jump in about two years—according to data released by…mortgage-finance giant Freddie Mac .

Lenders and real-estate agents say that, even now, all but the most qualified buyers making large down payments face borrowing rates of 5%.

Rates have been edging higher in recent months, but “the last week we’ve seen an explosion higher in mortgage rates,” said Rodney Anderson, a mortgage lender in the Dallas area.”

The increase in rates can be seen in the chart below which tracks mortgage rates since the financial crisis.

Source: The Wall Street Journal

While mortgage rates remain low by historical standards, they are significantly higher than they were a few years ago and that presents potential problems for the home market.

Rates Are Affecting Home Prices

It’s not surprising that the increase in rates should have an impact on home prices. Affordability is an important concern to home buyers and higher interest rates take money to service, lowering the amount of money buyers can apply to principal repayments.

The rise in borrowing costs can be a direct hit to household income. For a house with a $250,000 mortgage, rates of 5% add about $150 to the monthly payments compared with the rate of 4% that borrowers could have had less than a year ago, according to LendingTree Inc., an online loan information site.

That amount excludes taxes and insurance. In recent years, investors have seen both factors increase in some areas.

Taxes are no longer fully deductible for home owners in some parts of the country. The Tax Cuts and Jobs Act (TCJA) limited the ability of taxpayers to deduct state and local taxes (SALT) from their federal taxable income.

The impact of this change in the tax law is potentially impacting taxpayers in a number of states as the chart below shows.

Source: Tax Policy Center

This is a factor that is combining with higher mortgage rates to affect home prices and the results of the changing environment are already showing up in the housing market.

The next chart shows the rate of change in home prices. Low rates fueled a rapid recovery in home prices but the impact of rising rates is now slowing the rate of change.

 

Source: The Wall Street Journal

According to experts, “Higher mortgage rates have also slowed the housing market more than many expected. That’s a potentially troubling sign for the broader economy, since housing is often a bellwether for how rising interest rates could affect growth overall.”

Many buyers who are struggling to find a home they can afford because of high prices are more sensitive to rising rates than they have been in the past.

Existing home sales fell in August from a year earlier, the sixth straight month of declines. Many would-be buyers sat out the buying season because of high housing prices, a historic shortage of homes to buy, and a tax bill that reduced some incentives for homeownership. Higher mortgage rates will likely compound their hesitation.

“With the escalation of prices, it could be that borrowers are running out of breath,” said Sam Khater, chief economist at Freddie Mac.”

Higher rates will be hardest on first-time buyers, who tend to make smaller down payments than older buyers who have built up equity in their previous homes, and middle-income buyers, who can least afford the extra cost. Mr. Khater said that about 45% of the loans that Freddie Mac is backing are to first-time buyers, up from about 30% normally, which also means that rising rates could have an even bigger impact on the market than usual.

Younger buyers are also more likely to be shocked by higher rates because they don’t remember when rates were more than 18% in the early 1980s, or more recently, the first decade of the 2000s, when rates hovered around 5% to 7%.

“There’s almost a generation that has been used to seeing 3% or 4% rates that’s now seeing 5% rates,” said Vishal Garg, founder and chief executive of Better Mortgage.

Looking Beyond Home Prices

Higher rates will affect other financial activity

One obvious example is that higher rates will likely kill off any lingering possibility of a refinancing boom, which bailed out the mortgage industry in the years right after the 2008 financial crisis.

If rates hit 5%, the pool of homeowners who would qualify for and benefit from a refinance will shrink to 1.55 million, according to mortgage-data and technology firm Black Knight Inc. That would be down about 64% since the start of the year, and the smallest pool since 2008.

Another example is found in the wealth effect.

The wealth effect is a theory suggesting that when the value of assets are on the rise, individuals feel more comfortable and confident about their wealth, which will cause them to spend more. This was discovered many years ago.

“In 1968, for instance, economists were mystified when a 10 percent tax hike failed to put the brakes on consumer spending. Later, the sustained spending was credited to the wealth effect. Even though disposable income declined because of the additional tax burden, wealth continued to grow because the stock market persistently climbed higher.”

A home is often a family’s largest asset and now that home price gains are slowing, the wealth effect could work in reverse, making families feel poorer. This could lead a decline in spending, especially on big ticket items like cars and new appliances.

That, in turn, could fuel an economic slowdown and that could trigger a decline in the stock market. We are now at the point where investors must be concerned and that could require more defensive postures on the part of investors.

 

This is the time of year when retailers tend to deliver strong results. And, this year, retailers are in the news. One problem for the industry that stands out is Sears.

News reports indicate that “Sears Holdings Corp. (Nasdaq: SHLD) has hired M-III Partners LLC to prepare a bankruptcy filing that could come as soon as this week, according to people familiar with the situation, as the cash-strapped company that once dominated American retailing faces a debt payment deadline.

Employees at M-III Partners, a boutique advisory firm, have spent the past few weeks working on the potential filing, the people said. In recent days, M-III staff have been at the retailer’s headquarters in Hoffman Estates, Ill., one person said.

Sears continues to discuss other options and could still avert an in-court restructuring, the people added.”

The move in Sears is not a surprise. The stock has been trending lower for an extended period of time.

The company has been losing money for years, and has $134 million in debt due next week. Edward Lampert, the hedge-fund manager who is Sears’s chairman, chief executive, largest shareholder and biggest creditor, could rescue the company, as he has done in the past by making the payment.

But Lampert is pushing for a broader restructuring that would include shaving more than $1 billion from Sears’s $5.5 billion debt load, selling another $1.5 billion of real estate and divesting $1.75 billion of assets, including the Kenmore appliance brand, which he has offered $400 million to buy himself.”

The question for traders is whether Sears is part of a larger trend in the industry.

There Is Room for Optimism in the Industry

One of the techniques analysts use to forecast trends in the retail sector is to look to projections from the National Retail Federation.

Barron’s noted that, “The NRF said it expects retail sales in November and December—excluding automobiles, gasoline and restaurants—to increase between 4.3% and 4.8% over the year-ago period, or to about $717.5 billion to $721 billion, says NRF chief economist Jack Kleinhenz. The sales rise projected compares with an average annual holiday season gain of 3.9% over the past five years.

Additionally, retailers have been preparing for their busiest season of the year by hiring extra staff to help meet the demand expected during the coming holiday season, despite an increasingly tight labor market, the NRF said in a press release. The national retailers’ trade organization says it expects temporary hiring of between 585,000 and 650,000 workers in this period, up from last year’s 582,500 in November-December.

The NRF forecast reflects the overall strength of the industry, he says, thanks to a healthy economy and strong consumer confidence. “It’s consistent with the strong economic growth we have seen in the last couple of quarters,” he adds. There’s “solid momentum” in the fourth quarter and most retailers will see improved sales, he says.

Last year at this time, the NRF had predicted a 3.5% to 4% retail sales rise in the holiday season, but that was too conservative and the number turned out to be 5.3%.

Kleinhenz notes that last year’s prediction came ahead of the excitement created by the prospect of tax cuts and the actual reductions, which were approved in December. That led to an unanticipated rise in animal spirits. Typically, November and December make up nearly 20% of a retailer’s annual business.

In all of 2018, NRF estimates a 4.5% rise in U.S. retail sales over 2017; the first eight months have already posted a 4.8% to 4.9% rise. However, this holiday season, “We are going to have to lap that strong 5.3% number from last year.”

While there are concerns about the impact of an escalating trade war, the pace of economic activity should continue to increase through the end of the year, the NRF said. Holiday sales in 2017 totaled $687.87 billion, also a 5.3% increase over the year before and the largest increase since the 5.2% year-over-year gain seen in 2010 after the Great Recession.”

This is consistent with steady gains in sales that can be seen in data from the Federal Reserve that is shown below.

Source: Federal Reserve

Potential Winners

In this environment, there are likely to be some winners in the retail sector. Among the winners, as always, are likely to be the largest companies in the sector which include Amazon and Walmart. These stocks are generally in long term uptrends but could be considered long term investments.

The leaders are simply so large that a strong holiday season is unlikely to push the stock higher by a significant amount. However, a disappointing quarter could result in a significant sell off in the stock and risks should be considered when considering these stocks, and any other stock.

Smaller retailers may be more responsive to a strong quarter.

Among the retailers that could deliver good news is Dollar General Corporation (NYSE: DG). This company has delivered steady growth in an importer metric for years and management expects that trend to continue.

The trend of the stock price has also shown a positive trend as shown on the chart below.

Dollar General has been attracting consumers by adding consumable items like paper products and foods that are priced between $1 and $5. The company is also adding tobacco products and expanding its cooler facilities to increase sales of perishable items.

The results of this strategy could have helped the company extend its long record of reporting same store sales growth. Last fiscal year, which ended on February 2, 2018, the company recorded its 28th consecutive year of same store sales growth.

This year, the company remains on track to extend that streak after same store sales grew 2.1% in the first quarter of fiscal year 2019 and 3.7% in the second quarter.

Selling tobacco and food should help the company meet management’s goal to increase same store sales by about 2% this year.

Despite bad news in the retail sector, the holiday season is likely to have winners and losers and traders should have opportunities to profit from both.

 

Commodities markets tend to be different than the stock market. Some of the participants in the commodities markets are seeking a way to buy or sell raw materials that are critical to their business operations.

One example is a company like Campbells which makes soup and other food products. As a hypothetical example, Campbells could be a large consumer of corn for its soups. The company has sales and production estimates and can schedule when it desires deliveries of corn.

This knowledge would allow the company to enter the commodities market. Their traders could buy contracts of corn futures for delivery at some date that will meet its demand. This allows Campbells to lock in the price of raw materials.

Notice the purpose of the investment is not so much to make a profit as it is in the stock market and for some participants in the futures markets. Campbells, in this hypothetical, is controlling its costs to steady its expenses.

There could be farmers taking the other side of that trade, which would allow the producer to lock in a sales price and perhaps allow for a known amount of profit in a volatile market environment.

This process could be repeated for coffee companies which could buy contracts for beans on the futures markets; for candy makers who can lock in their costs for cocoa and sugar; for jewelry makers could be matched with gold and silver miners and for other producers who can match needs with producers.

Unlocking Trends of the Large Commodity Traders

For futures markets, the Commodity Futures Trading Commission (CFTC) collects and publishes detailed data on what different traders are doing. The CFTC is the regulator of futures markets, serving a role that is similar to the Securities and Exchange Commission (SEC) in the stock markets.

Every week, the CFTC releases a report called the Commitment of Traders (COT) which provides insight into the market action. Large traders are required to report their positions every week and this allows the CFTC to classify traders into one of three groups.

Large speculators are traders holding several thousand contracts in an individual market. These traders include hedge funds and large institutions. Commercial traders are those that use the futures markets to hedge their commercial activities. In grain markets, farmers would be an example of commercials. All other traders are considered to be small speculators.

The COT report identifies the positions of each group. Analysts have developed techniques to analyze this data with some general assumptions.

Generally, commercial traders are considered the “smart money” and small speculators are viewed as the “dumb money.” Commercials are in the best position to understand the market, which makes them the smart money. Small speculators are individual futures traders and they are believed to be wrong more often than they are right, making them the dumb money.

Large speculators tend to be trend followers. They will generally be wrong at major turning points but they will be on the right side of major trends. For many analysts, this group can be ignored because the opinions of the smart money commercials and dumb money small speculators offers insight.

Putting COT Data to Work

Raw CFTC data can be difficult to interpret. The report itself is a collection of numbers provided in text format by the regulator. Recent data for the wheat market is shown below.

Source: CFTC

Because the report can be difficult to interpret, some data services convert the data into an index.

In the chart below the data has been converted into an index showing the degree of bullishness or bearishness relative to the past six months. At the bottom of the chart, commercials are shown as the green line and small speculators are shown as the red line. The black line is the large hedge funds.

In gold, individuals and large traders are bearish while commercials are bullish. A large price move in gold appears likely. Since commercials are likely to be on the right side of the market, the move could be an up trend.

This same pattern is seen in the chart of corn below.

Here, small speculators are on the same side of the market as the commercials. Again, the commercials are the smart money in any market and they are bullish.

The chart of copper is shown next.

The pattern is a familiar one with commercials near their most bullish level in the past six months.

Finally, a chart of coffee is shown.

Once again, the pattern shows commercials near their most bullish level in the past six months.

What This Means For Investors

It’s unusual to see a similar pattern among the commercials in such diverse markets. We have looked at a chart from the precious metals market, an agricultural market, an industrial market and a market known among futures traders as the “softs” which includes coffee.

Commercials are buying as prices are falling. This seems to indicate that the commercials expect higher prices. Remember that commercials are the smart money in the market and are often correct in their market views.

It is not uncommon to find the commercials bullish after a price decline. However, the near uniform bullishness of commercials in diverse markets raises concerns about potential inflation.

Higher inflation would lead to higher interest rates. This view, and the bullish positions of commercials in the futures markets, would support the sudden surge in long term interest rates that has caught many traders by surprise.

Inflation tends to arise suddenly and the Federal Reserve, and other central banks, are then forced to react to the surge in prices. They often raise rates rapidly, more rapidly than the market expected, and this can lead to a sell off in the stock market.

For now, the warnings are becoming increasingly apparent. Inflation is not here yet, but the market data suggests that inflationary pressures are building. This could result in a stock market sell off, especially on days when official inflation data reports are released.

Traders should prepare for the possibility of inflation and take positions alongside commodity commercials whenever possible.

CNBC personality is fond of saying that there’s always a bull market somewhere. He certainly seems to be correct. There always appears to be a market that is going up. It might be a sector in the U. S. stock market, or the equity market in a foreign country or a commodity market.

Although he might not say, there is at least one corollary to Cramer’s observation. It’s equally likely to be true that there is always a bear market somewhere. And, as investors who follow the news may know, there always seems to be a crisis somewhere.

For crisis hunters, Europe has been an almost constant source of problems. Greece is a well known hot spot with bailouts propping up the country financially and the stock market showing the financial stress.

Global X MSCI Greece ETF (NYSE: GREK) is an exchange traded fund, or ETF, that tracks the Greek stock market and is one way for investors in the U. S. to trade that market. The ETF is more than 60% below its 2014 high, a sign that investors believe the country still hasn’t recovered.

But, Greece is just one potential crisis in Europe. In recent weeks, investors have turned their attention to Italy.

Interest Rates Often Lead the Way

One forward looking indicator of the economic strength or weakness in a country is the bond market. In Italy, that market is warning investors of potential problems.

Interest rates on benchmark 10 year government bonds are at multiyear highs and have moved sharply higher in recent weeks, an indication of a rapid change in the perception of the market.

Source: Bloomberg

One expert who has been following the market closely is Bill Witherell of Cumberland Advisors. He believes the political situation in the country is important to watch.

Witherell  notes, “The populist coalition government of the anti-establishment Five Star Movement and the far-right League party, formed in late May, surprised markets [recently] by sharply increasing its government budget deficit targets for 2019–2022, including the Five Star election promise of a “citizenship income,” a form of universal basic income, and the League’s promise of tax cuts.”

Those programs will be expensive to deliver and that showed up in the coalition’s budget proposal.

“The projected budget deficit of 2.4% of GDP for each of the next three years is three times the 0.8% deficit target for 2019 agreed with the European Commission last year, with improvements to 0.0% predicted for 2020 and a 0.2% surplus for 2021.

The Italian government has to submit a draft budget to the European Commission no later than October 15.” That sets a deadline and could set off an intense market reaction as the date nears.

It’s likely that tensions between the European Commission and Italy over the budget will increase. Initial “comments from the Commission already signal that they consider the draft budget to be incompatible with the stability and growth pact.”

Witherell noted that there is an important sector for traders to watch:

“The most immediate concerns about these developments relate to Italy’s banking sector. Declining values in the Italian bond market erode the balance sheets of Italian banks. At the end of last year Italian government bonds were reported to account for about 10% of Italian bank assets.

In the second quarter of this year Italian banks increased their holdings of Italian government debt by more than 40 billion euros as foreign investors fled the market. Italian banks are thought to hold over $440 billion in Italian bonds.

They are not the only banks at risk. French banks still hold some $319 billion in Italian bonds. German banks have reduced their holdings to $95 billion.”

The Italian Economy Minister, Giovanni Tria, argues that this isn’t a long term problem. He believes that, in effect, Italy will be able to grow its way out of the deficits and that the programs proposed in the budget will contribute to growth.

He forecast growth of 1.6% in 2019 and 1.7% in 2020. Growth was 1.6% in 2017. This year the economy looks likely to achieve growth of about 1%.

Tria could be optimistic. The European Commission expects Italy’s economic growth to be about 1.1%. Other experts agree that the economy is lower than Italy’s government acknowledges.

According to Markit, the Italian economy appears to have stagnated in the third quarter. The manufacturing sector has weakened through the year with overall growth relying increasingly on a still strong service sector.

Domestic demand is weak with depressed real incomes. Forward-looking indicators suggest very little growth in the fourth quarter. Italy’s stock market is now showing weakness.

U.S. based investors can gain exposure to the Italian stock market with the iShares MSCI Italy Capped ETF (NYSE: EWI). The monthly chart below shows that this market may have reached a significant top last year and it is now about 15% below that high.

One way to benefit form a decline in prices is sell the ETF short. This requires borrowing shares from your broker to sell and eventually buying the shares back to repay that loan. If EWI falls before the shares are bought, the position will show a gain.

However, there are a number of risks associated with short selling. The loan can technically be called by the broker at any time and the loan does carry a cost that can vary with market conditions. It is possible these factors could work against a trader with a short position.

Put options can also benefit from a decline in value. A buyer of a put option has the right, but not the obligation to sell 100 shares at a predetermined price until a prespecified date. Put options can deliver large gains and buyers of the options have risk limited to the purchase price of the options.

It is possible the crisis in Europe will worsen and Italy could be one of the biggest problems. That means put options could deliver large gains and could be a hedge against a market crash in that region.

 

A recession is near. At least that’s the conclusion of many economists who are analyzing the length of the current economic expansion and growing increasingly concerned about the length of time since the last recession ended.

Formally, a recession is defined as a time “when the economy declines significantly for at least six months. That means there’s a drop in the following five economic indicators: real GDP, income, employment, manufacturing, and retail sales.

People often say a recession is when the GDP growth rate is negative for two consecutive quarters or more. But a recession can quietly begin before the quarterly gross domestic product reports are out.

That’s why the National Bureau of Economic Research measures the other four factors. That data comes out monthly. When these economic indicators decline, so will GDP.”

This definition is more accurate and confirms with what we can see on the chart below. This chart is from the Federal Reserve. It shows the annual rate of change in GDP. Recessions are shown as grey bars. Notice that the rate of change in GDP usually remains above zero even during recessions.

Source: Federal Reserve

We can also see in that chart that the rate of change turns down before the recession begins in almost all cases. There are just two times out of eleven when the rate of change peaked in the quarter before the recession.

Right Now, A Recession Is Unlikely

Economists can never know a recession exactly when a recession starts or stops in real time. They need to observe trends in the data and the official start and stop dates are released months after the recession begins or ends.

Official recession announcements are made by the National Bureau of Economic Research Business Cycle Dating Committee.

The committee’s determination of the peak date in December 2007, the peak being the beginning of the recession, occurred 11 months after that date and the committee’s action in determining the trough date of June 2009 occurred 15 months after that date.

In the past, previous determinations of recession dates took between 6 and 21 months. There is no fixed timing rule. The committee waits long enough so that the existence of a peak or trough is not in doubt, and until it can assign an accurate peak or trough date.

The entire history of business cycles is shown below.

Source: NBER

While we won’t know when the next recession begins for at least six months, it is important to consider what a recession can mean for investors.

An Average Recession Can Be Devastating to Investors

The Committee divides their data into several different groups.

Source: NBER

The average of all cycles is shown, and this might seem to be the most relevant since it includes the most data. But, that is misleading because there is a clear trend in the data that the business cycle has become smoother over time.

The NBER includes some of the brightest economists in the world and it is reasonable to assume the dates they selected for dividing the data are not arbitrary. In fact, in one study, the NBER was ranked as the second most influential domestic economic policy think tank (the first was the Brookings Institution).

The Brookings Institution is influential because its team includes individuals like the former Chairs of the Federal reserve Ben Bernanke and Janet Yellen. The NBER includes Nobel Prize winning economists Angus Deaton, Lars Peter Hansen and Robert J. Shiller among others.

Digging into the divisions, we can see that the first time period, from 1854 to 1919 includes the time before the Federal Reserve. This was a period when the United States was on a gold standard, when it followed a bimetallic standard using gold and silver and was defined by other hard money policies.

It’s interesting to recall that the use of silver as a monetary base was a hotly debated topic in the Presidential election of 1896. It is difficult to envision the public debating monetary policy in the modern era but that was the time included in the first division of the NBER data which was from 1854 to 1919.

During this time, the time to peak to trough, the length of the recession, was the longest with an average of 21.6 months. Expansions were also the shortest with an average of just 26.6 month. The time between business cycles averaged about 4 years, coinciding with the length of the political cycle.

In this time, the average citizen experienced frequent booms and busts and in light of that reality, a focus on monetary policy makes sense.

In 1919, the United States economy was recovering from the First World War and the Federal Reserve was setting monetary policy. But, initially the Fed was focused by region. This meant, for example, that the branch in St. Louis or Kansas City could favor policies to help farmers while the New York branch was more focused in commerce.

Regional divisions in the Federal Reserve have been cited by some experts as one of the reasons for the Fed’s relative ineffectiveness at times during the Great Depression. The Fed was not wholly ineffective and did make some progress in reducing the average duration of recessions and lengthening the average expansion.

The final division in the data is the post World War II era. This is a time when the Fed operated cohesively and the economic situation was normalized after the Great Depression and the war years which included artificially low interest rates.

Now, the average recession is significantly shorter than the average expansion. And, that means the current expansion is not necessarily doomed solely because of its length.

That means investors should be prepared for additional gains in the bull market. The next recession is likely at least six months away since a downturn in the rate of change of GDP should be seen before the contraction begins.

Now, a bear market will likely occur months before the recession so that is a concern but for now, the stock market is generally in an up trend and investors should be mindful of a bear market but should not be so conservative that they miss out on gains.

 

 

 

Interest rates have been on the up swing for some time. The Federal Reserve has been raising interest rates since December 2015. That’s almost three years and analysts now believe the Fed has finally gotten rates to a level that can be considered neutral.

Fed Policy Can Be Broadly Classified Into One Of Three Categories

Accommodative policy is associated with easy money and the Fed is generally lowering rates under this policy. Restrictive monetary policy is generally associated with rising interest rates. A neutral policy is the transition between the two.

In a recent speech, Federal Reserve Chairman Jerome Powell said he did not see signs that inflation would spike despite the low unemployment rate. He also noted he could see monetary policy moving towards a more restrictive regime.

“Many factors, including better conduct of monetary policy over the past few decades, have greatly reduced … the effects that tight labor markets have on inflation,” Powell said in a speech to the National Association for Business Economics.

MarketWatch explained, “Standard central-bank theory for decades, known as the Phillips curve, has posited that tight labor markets lead to higher inflation. The explanation is that employers push up wages to compete for scarce workers and that their rising labor costs feed into prices paid by consumers.

Powell said that the Fed’s 2% inflation target policy seems to have short-circuited this process or, in other words, is holding the Phillips curve “flat.” People don’t expect higher inflation when they know the Fed will be aggressive to keep prices rising 2%.

In his speech, Powell said he was not worried the Phillips curve “will soon exact revenge.”

He welcomed the recent rise in wages and said it “does not point to an overheating labor market.”

The baseline forecast of the Fed shows unemployment rates remaining below 4% and inflation steady at 2% through the end of 2020.

Powell said he and his colleagues “stand ready to act with authority” if inflation expectations move upward.

The Fed chairman said the economy appears to be operating “with limited slack.”

He defended the Fed’s approach of raising short-term interest rates gradually. Moving rates up too fast “could needlessly foreshorten the expansion,” he said. Moving too slowly could risk a rise in inflation expectations, he added.”

The 10-year Treasury note yield moved above 3.16%, its highest level since July 2011.

Hedge Funds Benefit From the Move

Surprisingly, to some analysts, the smart money in in Treasuries has been on the wrong side of the market.

Information on which groups are buying and selling in futures markets is available from the Commodity Futures Trading Commission’s Commitments of Traders (COT) report.

That report details the positions of large speculators, which include hedge funds. It also provides data on individual investors and traders known as commercials which include the largest investment banks.

Weekly updates to the data show changes in the positions of each group. Tracking the changes can be profitable for traders. As a group, large investors tend to outperform small investors. But, large speculators tend to be trend followers. Commercials tend to be value investors.

The chart below shows the COT report for ten year Treasury futures. The green lines are the commercials. Large speculators are the black line and small speculators are the red line.

With hedge funds having significant profits, they may add to positions, or shift money from stocks to Treasuries. Their next action is largely unpredictable. But, when they act it could have significant repercussions on the stock market.

What This Could Mean for the Stock Market

As some analysts have noted, higher interest rates are only a problem when they are a problem. In other words, rates can rise for some time before the economy slides into recession or before the stock market suffers a sell off.

The chart below shows that rising rates often, at some point, do lead to a bear market in stocks. The rising rates may not cause the bear market and the cause may never be known. But rising rates seem to coincide with bear markets often enough to be a concern.

In the chart, bear markets in stocks are shown with pink shading.

Source: Yardeni.com

As to why interest rates are rising so quickly, the one-time Bond King Bill Gross, now the manager of the Janus Henderson Global Unconstrained Bond Fund, tweeted that:

“Euroland, Japanese previous buyers of 10yr Treasurys have been priced out of market due to changes in hedge costs. For insurance companies in Germany/Japan for instance, U.S. Treasurys yield only -. 10%/-0.1%. Lack of foreign buying at these levels likely leading to lower Treasury prices.”

Source: Twitter

Of course, markets move quickly and factors could switch to favor the US market again. But, for now, Gross is looking at a lack of foreign buying as a reason for higher interest rates.

Now, analysts have different opinions. At least one sees the recent market action as setting up a potential up move in the stock.

“A nice spike in U.S. yields is just what markets needed, given how quiet things had got lately. Volatility has been trending lower all year, so a little rerun of the January panic over U.S. inflation and yields would clear the deck nicely for an autumn rally in equities,” Chris Beauchamp, Chief Market Analyst at IG, tells clients in a note, according to MarketWatch.

Others have a more complex view.

Robeco fund manager Jeroen Blokland, says a gradual rise in yields, corresponding with strong U.S. data, is viewed as positive and “adds to normalization of monetary policy.

“However, the last couple of days the rise in yields has been fast and a bit unexpected. Most investors seem to be positioned for a decrease in yields. Fast rising rates brings corporate debt sustainability into play,” he said, via email.

Still, he says, investors don’t need to reach for that panic button yet. “So if rates keep rising like this I expect volatility in equity markets, but as long as they don’t ramp up to let’s say 4% or so, I think this should be seen as positive. Also the yield curve is steepening, reducing recession odds,” said Blokland.

One thing is clear. Investors shouldn’t panic. They should stick with their plan no matter what interest rates do.