**Earth Shattering June Rally**
Trade concerns fade as investors focus on the steady economy.
We are pleased to report that accounts hit all-time highs with one of the best June’s in generations. As we explained in the last letter, “this year’s combination of low interest rates and exciting companies is an attractive mix.’ So after one of the strongest starts on record, then a May pullback, June delivered an astounding rally despite almost universal doubts. Ironically all of this ‘worry’ creates a strong outlook for your investments.
Endemic pessimism supports further gains—A recent article from Bloomberg, “Data Can’t Convince Americans the Economy Is Doing Well,” relates how many Americans don’t believe they are well off even though household credit is strong and wages are rising. As we have discussed at length, heightened pessimism deeply affected investors after the Financial Crisis and is paradoxically a major factor driving your investments higher. The economic mix of wages employment and low interest rates are far better than people think.
- Hypersensitivity has been focused on the ‘trade war’ with China, fears about an unseen recession, plus a fixation on an “inverted yield curve” said to (incorrectly we believe) signal a slowdown. Investors have also been overwhelmed by the Smartphone effect that compresses unreliable market prognostications into negative newsfeed clusters. Yes, market movements are ever unpredictable and feel random, but the overall trend has been good— your investments are at all time highs, after all.
Trade talks have driven a lot of market fluctuations, but finally settled into a rough acceptance by most Americans that trade negotiations serve our national goals. China is an asymmetric trade opponent; a revised trading framework has bipartisan support, even if trade experts would prefer a coalition negotiating strategy over the unilateral tack of the present administration. China has subsidized tariffs so far with a weaker Yuan, cushioning the effect on US consumers. China has been exporting at cost as part of their overall strategy, where financial subsidies to their exporters ensure gains in technology and industrial processes.
- The foregoing may indicate China is in a more vulnerable position than commonly believed; forced to defend market share with costly government stimulus and currency intervention.
American consumers have so far been cushioned. Retail sales are healthy and import prices are subdued. Walmart’s last earnings report pushed its stock to fresh highs—US retailers are resourcing away from China. Some notable items, like bikes, are moving to Taiwan, and costs have been diffused amongst the panoply of goods sold in our 20 trillion dollar economy. Some markets are positively affected. US garlic harvests in Gilroy California, are doing better after years of aggressive Chinese garlic dumping into the US. A lot of Americans don’t agree on everything, but maybe everyone’s breath will be a little better!
Federal Reserve’s Low Interest Rates Spur a Rally in Stock and Bonds.
The Fed Valuation Model: stocks are simple; companies are part of the economy, which grows, they make earnings, and earnings have value. The Federal Reserve actually compares earnings to interest rates in order to value stocks. Are they high or low? The Fed pays attention, and they would be the most bullish advisor of all; using their formula stocks should be far higher. For decades the relationship between company earnings and interest rates was stable, but after the Internet Bubble, 9/11, Recession, stocks—even though now at highs—are persistently below where the Fed predicts they should be. While this deep risk discount is part of our time, it is coincidently hugely supportive of continued appreciation. It’s really why stocks keep on going up.
- Stocks are undervalued by this yardstick, highly so, despite the discomfiture that investing can bring. In January we told you that “Peter Lynch, the famous manager of the Fidelity Magellan Fund, swore by the ‘price to growth’ or PEG ratio as a fundamental guide. It has fallen below the magic ratio of 1, meaning growth is free and paid for by earnings.” We were right, and while stocks are now nicely higher they have far to go based on sentiment indicators.
The ‘Bond Smile,’ our new sentiment analysis paradigm. There has been a lasting change in the pricing of the treasury market following the financial crisis. In normal times, the yield curve would be a gently rising hill. Interest rate term structure meant that you wanted more for tying up your money longer. Today, the shape of the yield curve has permanently changed, and no longer reliably forecasts the economy. It now resembles a utility wire dipping in the middle, what we have termed The Bond Smile. Most market commentators mistakenly call this an ‘inverted yield curve’ then fret about the prognosis. Nothing is further from the truth. There’s more money in the world than ever, but a lot of it just sits in deep pools of low yielding treasury bonds.
- It’s not an indication that the economy is bad now or will be in the future. It is an indication of very high risk aversion which is a major extremely bullish sentiment indicator and supportive of stocks.
The last employment report threaded the needle between growth and moderation, delivering the exact chemistry that the Fed, investors, and trade negotiators needed. As the presidential cycle heats up, we ask that you make an appointment with us to discuss this Letter and our investment outlook— And please don’t hesitate to share our approach when you have an occasion to recommend us!
MWS Capital Consultants LLC
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