July, 2018
By Darren Nyce, CFA
Senior Research Analyst, Castle Investment Advisors®, LLC

We recently completed our family vacation to the island of Jamaica. We enjoyed staring at the ocean for hours while enjoying the amenities of our all-inclusive resort. One of the biggest perks, particularly for my wife, was the luxury of not having to plan meals. At the breakfast buffet, we found ourselves presented with a cornucopia of options – pastries, bagels, waffles, pancakes, bacon, omelettes, fruit, oatmeal, sausage, cereal…something for everyone. Our kids would survey the choices and inevitably come back to the table with a plate full of sugary carbs. Despite mom’s prompting to include some protein, the distraction of sweet flavors usually carried the day (after all, there’s probably some egg in the French Toast).

In 2018, our news headlines are as diverse as a breakfast buffet; we tend to be drawn to our favorites with the inner voice of reason reminding us to pay attention to meaty things as well. Here’s some of what was available on the smörgåsbord of current events during the second quarter:

  • Royal Wedding – Prince Harry and Meghan Markle become Duke and Duchess of Sussex
  • Italian power shift – An anti-establishment coalition takes over
  • Triple Crown – Justify wins horse racing’s most prestigious title
  • Summit with Singapore – President Trump meets with Kim Jong-un
  • Tariff Talk – Threats and counter-threats lead to concerns about a trade war
  • Immigration – Enforcing the rules while separating families evokes many emotions
  • World Cup – Soccer begins its quadrennial tournament
  • Hawaiian Volcano – Lava flows from Kilauea
  • Supreme Court - Justice Anthony Kennedy announces his retirement
  • NBA – Golden State wins again and Lebron changes teams
  • Interest Rates – The Federal Reserve raises rates for the second time this year

While all this was going on, the stock market has been attempting to recover from its mild winter correction. The S&P 500 produced gains for the quarter and is in positive territory for the year, though still below the high levels it reached in January. Growth stocks have outperformed value stocks and smaller companies have fared better than larger ones.

Index      1st Qtr 2018      
Return
1 Year
      Return        
3 Year
     Annualized      
Return
5 Year
     Annualized      
Return
S&P 500 3.4% 14.4% 11.9% 13.4%
Nasdaq Composite 6.6% 23.6% 16% 18.5%
Russell 2000 – Smaller Companies 7.8% 17.6% 11% 12.5%
MSCI EAFE – International -1.2% 6.8% 4.9% 6.4%
Barclays US Aggregate Bond -0.2% -0.4% 1.7% 2.3%

The economy has continued and accelerated its growth trend. With consumption making up 69% of the U.S. GDP, the benefit that consumers have received from lower taxes is being seen in increased spending. The economy has now been growing for 108 months, which is the second longest expansion on record. While expansions are getting longer because economies are becoming more stable, this inevitably leads to questions about when the next recession will arrive (not if). With the usual disclaimer about these things being difficult to predict, looking across the landscape of economic data, there is nothing that indicates that a slowdown is imminent, but the risks have increased for late 2019 and 2020.

UA Recession ProbabilitiesSource: Neuberger Berman, May 2018

Here are a few things that we think could lead to a cooling economy:

  • Higher interest rates – The Fed is expected to raise rates another 4 times over the next 12 months (to about 3%), this typically has a cooling economic effect.
  • Reduction of fiscal stimulus – The impact from lower tax rates both for individuals and corporations tends to be short-term, and the resulting higher level of deficits will require some collective belt tightening down the road.
  • Lack of new workers – Current forecasts point to an unprecedented level of low growth in the number of both native born and immigrants within the working ages of 16-64. This growth has been something we have always counted on as an element of economic expansion. 

Growth in working age chart

So how should you prepare for the eventuality of the next recession? 

Our response is first of all to remain appropriately diversified, a consistent theme from these letters. Additionally, keep in mind that the most recent recession we experienced was certainly not typical and it is likely that the next one will be less severe. It is also true that bull markets not only last longer than bear markets, but they also provide much greater positive returns than bear markets take away.

Cumulative Price Return

A few other data points that have caught our eye:

  • Employment – the percentage of unemployed workers has dropped to a remarkably low 3.8%. It is not surprising with fewer workers available that wages are rising (see chart to the right).

Civilian unemployment chart

  • Inflation – while rising, mostly due to the price of energy, it hasn’t yet become too high for the economy to handle.

Consumer Price Index

Price of oil chartSource: JP Morgan Asset Management, June 30, 2018

With this economic back drop, corporate earnings have been terrific. The companies in the S&P 500 are on track for a record high amount of Earnings per Share (EPS); growing a robust 20%. Though some of this growth is due to the recent tax cuts, the improvement is still extraordinary.

SP 500 Calendar Year Bottom up

Outside the United States, growth has been moderating, but is still solidly positive.

The international climate has been dominated by the possibility of increased protectionism brought about by the implementation of higher tariffs. Since peaking in 1930, the level of tariffs has decreased significantly. Now in the name of protecting American workers, President Trump is seeking to increase the taxes foreign countries pay for the ability to sell their goods to Americans. The domino effects that will result, including the potential retaliation from other countries, has many economists concerned. Some of the potential results could be more stock market volatility, higher inflation, and a weaker U.S. Dollar, with an all-out trade war being the worst-case scenario.

Tarriffs chart

On a lighter note, Twitter (TWTR) was added to the S&P 500 this past quarter, replacing Monsanto, which was acquired by Bayer. To commemorate this occasion, here are some recent tweets that I found humorous or interesting:

  • Puzzling headline from Bloomberg:
         - “Not enough cows are getting massages to produce luxury leather” @business

  • Something I had never thought of before:
         - George Washington didn’t know dinosaurs existed having died 42 years before scientists proved their existence @DidYouKnowFacts

  • I’m a sucker for math jokes:
         - “Not all math puns are terrible. Just sum” @mathway

  • My teenage daughter found this relatable:
         - “These GPA looking gas prices gotta go. Gas $3.89. Suma Cum Laude gas. I need academic probation gas.” @capt_thickness

  • For young parents:
         - “Get married and have kids so that you can be woken up at 4:56 am on a Saturday by someone asking what the opposite of “J” is.” @adult_mom

Have a great summer.

        DarrenSignature

Disclosures: 
Tax, legal, and estate planning advice contained in this article is general in nature. Always consult an attorney or tax professional regarding your specific legal or tax situation. This article was prepared for informational purposes only and does not constitute an offer to buy or sell, or a solicitation of any offer to buy or sell the securities mentioned herein. Information presented does not involve the rendering of personalized investment advice, but is limited to the dissemination of general information regarding products and services. It should not be regarded as a complete analysis of the subjects discussed. All expressions of opinion reflect the judgment of the author as of the date of publication and are subject to change. Any strategy discussed herein may not be suitable for all investors. Before implementing any strategy, investors should confer with their financial advisor. No current or prospective client should assume that the future performance of any specific investment, investment strategy or product made reference to directly or indirectly, will be profitable or equal to past performance levels.

Index 1st Qtr 2018 Return 1 Year Return 3 Year
 Annualized
 Return 5 Year 
Annualized Return
S&P 500 -0.8% 14% 10.8% 13.3%
Nasdaq Composite 2.6% 20.8% 14.3% 18.1%
Russell 2000 – Smaller Companies -0.1% 11.8% 8.4% 11.5%
MSCI EAFE – International -1.5% 14.8% 5.6% 6.5%
Barclays US Aggregate Bond -1.5% 1.2% 1.2% 1.8%
 
While market gyrations and the accompanying headlines can increase investor anxiety, stepping back and remembering that the goal of most investors is having an investment portfolio that thrives over decades, not days, helps put things in perspective. Don’t confuse mass media market commentary with financial advice – the former provides contextual information and entertainment; the latter should be personalized to your individual situation and goals.
Along these lines I recommend a recent blog by Josh Brown titled “Some Alternatives to Evidence Based Investing” where he lists some of your options if you don’t use a systematic approach to construct a durable portfolio.
http://thereformedbroker.com/2018/03/20/some-alternatives-to-evidence-based-investing/
Meanwhile, the economy continues its trend of slow growth. Responding to the recent tax cuts and more government spending, growth is expected to increase, at least in the short-term. 
Unemployment has fallen to 4.1%, a dramatic difference from the 10% we were experiencing in 2009. This is one of the lowest rates we have seen in my lifetime (since 1969).
                                    
Of course, this is great news for those of us who like to have jobs, but there is another side to this coin. We mentioned the economy’s slow growth, it has been averaging about 2.2% annual growth during the current expansion. The drop of the unemployment rate from 10% to 4.1% has accounted for about one-third of the growth we have experienced. Most economists agree that an unemployment rate of 3.5% is about as low as possible. Without the stimulus provided by putting more people to work, overall economic growth will be harder to come by in the years ahead.
It is also logical to expect that along with a tighter labor market, the growth of wages paid should continue to increase. 
The rise in Corporate profits was very solid in 2017 and with the benefit of significant tax cuts, 2018 should be excellent as well. The chart on the next page shows the combined annual Earnings Per Share (EPS) for the companies in the S&P 500 as well as estimates for the future. This will create quite a high bar for earnings comparisons in 2019 and beyond. Especially in an economic environment that is likely to see higher wages, higher interest rates and slower growth.
 
 
 
 
 
 
 
In addition to the U.S., nearly all countries in the world are growing, but none are booming. This should provide a certain stability to the condition of the global financial markets, at least for now.
Because of the economic growth and stability, the Federal Reserve has been comfortable continuing to move interest rates back toward a more normalized level. The Fed did raise rates in March and is expected to do so again another 2 or 3 times this year.
 
          
 
 
 
 
 
 
 
 
                              
Rising interest rates often present some challenges to bond investors. Most Castle clients will see among their bond investments things like Floating Rate Bonds, Convertible Bonds, and High Yield Bonds which have tended to do a little better as interest rates rise.
As expectations for 2018 earnings have increased, this has brought down the market’s valuation to a near normal level. Nerdy math alert: Forward P/E = stock market price divided by estimates of the next 12 months earnings; thus, a lower price or a higher earnings projection makes a lower P/E. This makes it more comfortable to be a stock investor this year, as there continues to be no signs of an imminent recession. But attention must be paid (and performance expectations adjusted) to the years following 2018 as continued earnings growth at this level will be challenging to maintain. As always you are encouraged to remain diversified and long-term focused.
I’d like to conclude this quarter’s letter with a personal note. My dad passed away earlier this year. Though he was not the kind of father to pull me aside and dispense quips of wisdom, he did teach me many important lessons most often through his actions. So as a tribute to him, I pass a few of these lessons along:
Protect your family, love your spouse
Hard work is good
You reap what you sow
Experiences are often more valuable than things
Cereals should be combined
Steak should be pink
Don’t strike out looking
Read the Bible
Live adventurously
Live up to the legacy you have received – leave a legacy to follow
Pay attention to the weather
Great things come from little beginnings - an entire stalk of wheat was once contained in a tiny seed
There are a variety of ways to be smart
Be someone’s mentor
Life is sometimes rough; comebacks will be needed
Thanks for reading, let your family know that you love them. Have a great spring.