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Notes and Thoughts Ahead of this Week’s Federal Reserve Meeting

  • Investors expect that the Federal Reserve will ease 25 basis points and that stocks will rally as a result. My feeling is that since this is the overwhelming consensus, it will not come true.  I believe the Fed will ease (because they all but promised that they would), but the market will not take off higher.  Maybe it will be because investors are disappointed by the future guidance or maybe because they just want to “sell the news”.  In any event, based on strong investor sentiment, I believe we are due for a correction.
  • I’ve listened to several fixed income conference calls over the past two weeks. Bond managers are very frustrated by the high prices and poor credit terms they are getting on corporate bonds today.  We’ve been running for two months on the narrative that eventually the U.S. will follow Europe and Japan into negative rate territory.  Again, I’m not arguing with this as a possibility if the economy slumps enough, but I don’t think it will happen soon.  I’d fade the bond rally as well right now (meaning that I would stop adding duration for now).
  • There is tremendous pressure these days on the idea of diversification, because the default assets – U.S. blue chip stocks and intermediate term treasuries – have done SO well this year. Diversification is one of those things that you need the most when you don’t think you need it.  Stick to your discipline.
  • Gold is one of the few diversifying asset classes that has performed well this year. The thesis for gold is that Chairman Powell has been brought to heel by President Trump and can be counted on to use interest rate policy to ensure a strong economy on Election Day, inflation be damned. I believe the risk to that scenario is not inflation (which is usually built up over a generation’s worth of monetary mis-steps) but the bursting of an investment bubble and the resulting deflationary contraction.
  • One of the biggest beneficiaries of very low interest rates are closed-end bond funds, because the leverage they used to boost yield just gets cheaper.
  • One of the hottest areas of the stock market over the past three months has been the financial technology (fintech) sub-sector, led by stocks like Visa, Mastercard, and PayPal. Investors believe that they are stealing share for (or disrupting) the banking sector.  This is a hard area to target with an ETF, but the Fidelity Sector fund FBSOX may be one way to play it.[1]
  • Late summer and fall is traditionally a weak time for real estate stocks, according to sector specialist Jay Kaeppel[2].
  • Recent currency weakness has been a blessing for European stocks. Many European stock markets are up 20% or more, but as dollar-based investors our gains are closer to 12-13% (unless we are using a hedged product such as the Wisdom Tree International Hedged Quality Dividend ETF (IHDG)).  Asia has not experienced currency weakness nor strong equity markets.
  • The best two foreign markets over the past few months have been Turkey and Argentina, where sentiment at year end 2018 was terrible. India, where sentiment was fairly positive after it held up fairly well in the fourth quarter of 2018, has done almost nothing this year.
  • Since the financial crisis, the direction of interest rates has been far more significant to stock prices than the rate of change in corporate earnings. There have been only two years this decade where future earnings revisions have risen during the course of the year – 2011 and 2018 – both down years for the broad stock market.
  • Two of the worst broad sectors this month have been energy and health care. Energy is suffering from over-production and transport issues.  Failing to rally in the face of the Iran situation and the warm summer is not a good long term sign.  I would stay  away from energy for now.  Health care, on the other hand, is probably interesting at this point.  Valuations have improved dramatically on fears of a much more regulated health care system.  The life sciences sub-sector (think Thermo Fisher and Danaher, for example) is doing exceptionally well.

-Mark Carlton, CFA

 

[1] Telemet Orion is the source of all performance data in this post.

[2] Real Estate’s Favorable Period is Winding Down, Jay on the Markets, 07/25/19

 

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