The Delta Group

A Financial Advisory Firm

Vol. 35, No. 1, Feb. 2019, Eric Drew Dahl & Patti Williams, Editors

The economy performed a remarkable feat, reaching the 4%+ GDP plateau in Q1, a level regarded as folly in our low growth post Great Recession paradigm. Following suit, the unemployment dropped to 4%, a level not seen in 50 years. Labor, steam-rolled by the globalization movement, was invited to the party scoring 3%+ wage gains. And, the market does what?! Pulls a 1987 – 23% one day loss – with a slow motion 20% crash in Q4, throttling investors over a painful ‘when will it stop’ ninety-day period.

The trade war/tariff battle (tax on foreign imports) with China combined with a two-dimensional Federal Reserve committed to higher rates schemes through 2019 torpedoed investor sentiment. Recession anxieties grew as short sellers (selling stock with borrowed funds) and margin calls (forced selling to cover capital shortfalls) drove the market lower, and lower, with final capitulation on Christmas Eve. The Fed, realizing their crystal ball might have a crack, offered a wait and see attitude towards 2019, essentially promising not to be stupid in matters unknown. Markets have rallied since.

Recession fears abated with news of 500,000+ job gains over the past two months, muting nay-sayers. Money poured back into both stocks and bonds (after record outflows in December) driving markets higher to recover over most of their 4 th quarter loss, advancing ~10% for the year. Small caps, having been hit the hardest have rebounded the strongest. Foreign markets continue their struggle.

The US separated itself from economies abroad, getting a boost from less restrictive tax and regulatory policies. Worries that tax cuts would push deficits higher were not realized. Tax revenues were flat, surprising critics. Entitlement spending jumped, a concern on these pages for the past oh 30 years, anticipating the Baby-Boomer’s draw-down on their retirement and health care benefits. Since ‘entitlement’ checks are cut from the Treasury’s general fund, not the ‘Trust Fund’ often quoted, we qualify them as promises, and not guarantees.

-2018 newsletter musings in italicsAbout our economic condition:

…add another 20% to market gains for ‘17. GDP growth… 3%, not seen since 2005,…supported record high valuations along with 10%+ profit growth. After years of political debate, U.S. corporate tax rate was cut to 21%, down from 35%.

Remarkably US GDP touched 4% in the first quarter, job openings surged over 7M+ while unemployment fell to 50-year lows. Wage growth exceeded 3% elevating the fortunes of the middle class. Profit growth touched 20%, boosting stock prices (at least temporarily) to all-time highs. Economically it was a remarkable year, which unfortunately caught the attention of the Federal Reserve and their commitment to ‘normalize’ (raise) rates to pre-Great Recession levels. Suddenly doubts were amplified regarding 2019’s prospects. Markets responded accordingly.

On the consumer side:

Expect further expansion of jobs and bonuses here in the US (see Apple/Exxon) as corporate bottom lines improve. The middle class will get the benefit of personal tax cuts, adding ~$2,700 to the net take home of an $80k income family. Pressured by record low unemployment, rising wages and higher net take home pay propelled holiday spending to record levels.

The Holiday shopping season set records with a 5% increase over 2017, driven by consumer confidence, 3% wage gains and a tax relief bump to take home pay. Housing sales were down, faltering with rising mortgage rates. Prices though continued to climb, with crazed demand from foreign buyers pushing West Coast values higher and higher. Overall record debt levels concern economists, but a corresponding jump in asset values as well as in-line income to debt ratios temper this anxiety.

On the investment side:

Stocks: The major theme of ’17 continues on into ’18. With the Fed’s desire to ‘normalize’ interest rates higher, bond prices as well as other rate sensitive sectors (real estate) have sold off a bit. Growth remains the winning sector ignited by both the tax cuts and an expanding world economy. Investors dismiss caution while embracing historically high valuations expecting corporate bottom lines to catch up.

Small caps lagged in ’17,…outperforming in ’16, a value trade rotation to regain the lead in ‘18 would be a reasonable bet.

Blue chip growth remained the winning sector posting a ‘zero’ gain for the year, while value stocks lost 9%. The big growth drivers (Netflix, Apple, Amazon etc.) took turns in the woodshed, but fared than most. As we stand today, the S&P 500 has recovered the majority of its loss, sitting just ~5% below the October ’18 peak. Smaller companies were less exciting and gravely punished in the liquidity seeking sell off, ending down ~11%. Foreign markets were hurt by a both a strong dollar and faltering growth prospects, losing ~15%. Remaining underweight in the overseas segment paid dividends.

At their worst point in December, valuations were very appealing, measuring ~14x earnings (vs 15x historical average.) The January rebound has raised valuations to ~17x, a decent bargain though caution is prudent. For many reasons, profit growth has fallen from 20%+ in ’18, down to mid-single digits currently. More clarity going forward and/or China trade resolution could spark a move higher, while falling retail sales a signal to send prices lower. Guess is that market volatility will be more subdued. If growth does indeed falter, a Fed rate cut could offer some protection to the downside.

Bonds: Encouraged by 3%+ growth, the Federal Reserve abandoned their zero-rate policy and began a series of gradual ¼ point increases better aligned with a healthier economy.

Good news becomes bad news, especially in the eyes of the central bankers, whose role is to protect the currency and keep inflation in check. A TV pundit critical of the Fed’s arrogance (stupidity) to chase down inflation suggested ‘labor’ was finally getting its due, and justifiably should let the economy run. The Fed’s use of year over year metrics, better suited to academic study, conflict with real-world Main Street economics (job growth, wage gains) that have lagged for decades.

If the Fed remains accommodating, funds will continue to flow into fixed income products.

Foreign: Emerging markets were the winners last year with 40%+ gains after many years of lackluster performance. This offers a great lesson of markets making little sense in the short term but years later with patience brings wealth.

Some reversal. A strong dollar in combination with China trades/tariff tensions dropped markets an average ~20%. Slowing growth rates in China, the emerging market benchmark, pulled the entire segment down. European investment suffered from a strong dollar (~10%) since US currency gains are dollar for dollar subtractions from foreign holdings.

The trade war with China, which started several decades ago, increased intensity with the President adding tariffs to force compliance. China has a weaker

hand to play with declining growth rates and financial excesses in their banking system. I would guess (hope) a quiet ‘saving face’ solution will emerge, but these negotiations can last for years.

Gold: …and continued 8% higher in ’17. Although cryptocurrencies (Bitcoin) now offer a competing ‘off the grid’ money exchange vehicle, metals ignored the new age nonsense, with more gains expected in ’18.

Gold dipped mid-year but recovered most of its loss. BitCoin, the ‘new-age’ upstart crypto-currency (encrypted) was infected by age-old virus aka ‘TulipBulb-Mania’, rising 400% before shedding 75% of its value and thousands of fortune seekers with it. Though lacking any real basis for valuation, BitCoin remains a clever method to avoid the banking system (prying eyes) and so will continue to expand as a functional alternative to cash.

Final thought: History tells us markets are driven to distortions: the DotCom bubble fueled by infinite internet wealth; the real estate bubble by free money lending; and, today, optimism perhaps a few clicks ahead of reality.

Markets drifted higher over the year, but ran square into the Ogres of October, losing ~20% off their highs. Trade tensions along w a Federal Reserve blindly committing to a rising rate schedule through 2019 added octane for short sellers and year-end tax loss selling. Selling begat more selling.

Consolation: The market lived past the ’87 crash, scoring a 17% gain in ’88 while the economy expanded 4%+, reminding us that the stock market is NOT the economy. Following suit, the January bounce is ~19% off the December low, replicating a similar response to a non-recessionary crash. Regardless, Merrill Lynch reports that professional managers hold their largest cash position since 2009. Sentiment, as the data suggests, has been a reliable contrarian indicator.

More reasonable stock valuations will dampen market dramas and should be less intense this year. Thanks to you all owning the knowledge that a long-term vision is more rewarding than short-term panic attacks.

The Delta Group announces the opening of a new office @ 453 Second St. W. in Sonoma, 707.343.1145. In Santa Clara County, our office is 100 S. Murphy Ave., Ste. 200, Sunnyvale. Your assistance in recommending potential new clients would be appreciated. Contact Eric @ 415.640.6770.

Happy New Year! Eric & Patti