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Manage the Funds Podcast

Expert insight on the financial topics that impact your bottom line

2018 1st Quarter market outlook


A conflict free, unbiased view on how we see economic fundamentals and the stock market coming together to drive our portfolio decisions. An inside look on how we do what we do for the first quarter of 2018.

Michael Carlin

Welcome to Manage the Funds Podcast. This is Michael Carlin, President of Henry+Horne Wealth Management. Joining us today is Steffan Dye, Vice-President of Henry+Horne Wealth Management.

We are bringing you our first quarter 2018 market outlook. We are going to give you the conflict-free, unbiased view of the way we see economic fundamentals in the stock market coming together to break down how we see this information come together and how we make portfolio decisions. This is an inside look as to what we do when we manage money.

Steffan Dye

I saw this week an interesting story about how money is pouring into the equity market. It’s at unheard of rates. Four-week inflows into stocks and the United States especially were at an all-time high. The largest ever. This is a combination of both institutional and individual investors just pouring it in there.

Michael Carlin

This is a sign of an all-time high. A sign of bear and bull excessiveness

Steffan Dye

It feels a little toppy to me. We’ve talked about this before when I used the face of a clock to understand where we are in the market cycle. If you can imagine the face of a clock, this looks more like an 11:00, 12:00, 1:00 than a 5:00, 6:00, 7:00 when you start seeing record inflows. The prices will go up when money flows in.

Michael Carlin

What I saw recently that is economically impressive was Ray Dalio. He was talking about the economy and everyone’s expectations when you read a lot of his sell side researches. With EPE growth here in the United States going to be greater than 3%, he was calling for numbers more than 2.5% to 2.75% range. We are going to dive into this deeper. When you have an institutional mind like Ray Dalio calling for 2.5% percent, looking at the Federal actions for 2018, it ducktails into the way we see the market coming together.

Let’s look at the number and research that we think is most important that helps guide you when you’re making portfolio decisions and thinking about your investment account. Last year should’ve been a good year for you. U.S. market big cap stocks were up 21%. Emerging markets – 37% and more last year. International stocks – the big countries anywhere from Europe to Japan up 25%. Small cap was in the equity side of only 13%. When you go down the list, stocks and bonds of all kinds – both government and high yield, even the alternatives long, short hedge funds – everything was working last year.

Steffan Dye

We like to look at the global market portfolio which is all the assets that you could buy weighed by how they are owned across the world. It’s the ultimate passive buy and hold portfolio. The world market portfolio was up just over 12%. You see some real big wins in emerging markets 37%.

Michael Carlin

Emerging markets tend to be volatile. We do want to caution everyone not get too excited about emerging market performance and dump a bunch of money in it. Look back historically. You’ll see emerging markets have a long, rich history of going up and down. We start looking at the best case scenario of what the market expectation is.

We look a lot at Alliance Bernstein’s research and they’re expecting global growth to be 3.2%. We’ve been doing this for 11 years in market outlooks. I can’t think of a year where global expectations weren’t high in January. I’ve seen a 3% global expectation for so long that historically, we haven’t delivered those numbers. People want to get so excited. You’ve seen Alliance Bernstein’s calling for 3.2%, but we’re more aligned with the Ray Dalio folks thinking 2.5% to 2.75%. We’re not so excited.

We’re trying to move a trillion dollar plus economy. Getting a 3% growth rate here in the United States would be great. We certainly have seen great quarters where we’ve been seeing that kind of economic numbers come through, but I’m not feeling quite as confident as some of the other sell side analysts.

Steffan Dye

For those of you listening, Ray Dalio is the manager of one of the largest hedge funds in the world and one of the most respected voices in forecasting in the world. The Dalio meeting that Michael was talking about is one of the meetings that hosts the best minds in economics and finance and global politics all over the world every year. It seems optimistic that 3% economic growth and Dalio talking about it being more likely in the twos. I’m feeling the excitement. A lot of times economists will project out what’s been happening recently. They have an optimistic bias and they’re putting out some big numbers.

Michael Carlin

Let’s not forget that we need to be a little negative, but Alliance Bernstein and those folks are sell side researchers and they want you to buy their funds and their optimism. We are trying to see through that fact and data and bring it to you straight. What we do is, we think inflation has been low and should continue to stay low, which is great. Ray Dalio thinks the same and neither he nor I are afraid of a little inflation. That typically is a good thing for wages. We can talk a little more about that later.

Fiscal policy is good. We are going to talk a little bit on how the tax plan is moving the economy forward and helping the stock market. If you’re looking at central banks, they are key and vital to creating this market environment that we have. It’s been easy money and it’s cheap money. You’ve had the Federal Reserve Central Bank here in the United States buying assets of all kinds. You have European Central Bank, PBOC in China. You have these different institutions that have been doing their own buying as well that supports the market. We are starting to see that punch bowl dry up. Especially in the United States with interest rates increasing. We are starting to see globally that starts to be a detractor moving forward.

Stephen Dye

The single most important factor for the run up since the global financial crisis has been the equity that the global central banks have provided. They say they don’t work in unison, but I don’t believe that for one second. I think they are on the hotline to each other and they are coordinating. The U.S. Federal Reserve Central Bank will indicate that they will start to pull back but then Japan will ease, and Germany will ease as Japan pulls back. The global equity has continued to grow. It’s flattened a bit, but we haven’t seen too many signs of pulling back the coordinated efforts but they’re talking about it. What keeps me up at night when I’m worrying about stock markets is what are the central banks going to do? When the global equity begins to dry up like you’re talking about that could mark the turn in the stock market.

Michael Carlin

For those of you who are looking for a key in the signal? Look for the Federal Reserves all over the world to be talking about what their monetary policy is going to do. Are they easing, or are they making things a little tight?

We want to switch gears. Let’s talk about consumer confidence and business confidence. The survey of consumer confidence not quite at an all-time high, but it hasn’t been this high since the dot com bubble in the late 90s. Small business confidence equaling all-time highs. So, to me, I see those signs of great supporters of our current economic growth. I see a great supporter of our current stock market environment. meaning those high measures give credence to explaining why the market is so high, but it doesn’t help make me feel better about the market moving forward because to me, I look at those measures and say, “Well goodness if it’s at a near all-time high is there only one place to go.”

Stephen Dye

What you’re describing fits with where I started about record bull run and equity flows. The monies and people are confident and looking and feeling good. I divide markets into a simple four quadrant box. The best markets are the ones that are inexpensive and going up, which is the one I want to be in. The worst markets are the expensive and going down. That’s the market we do not want to be in. Second best market is the one that’s expensive and going up, which is where we are now. I worry about things getting expensive. We are seeing both bonds and equities appearing to be pricey. If you look at one of my favorite measures, its price to earnings adjusted over a ten-year average.

My hero is Professor Shiller. I talk about this all the time. It will drive you crazy. Historically, you can get some pretty good information about what’s going to happen in the future with prices. The United States market is near all-time highs. When you look forward to these market valuations, typically you will see something like zero to negative returns over a ten-year period. So, we are in this great market and it’s the second best market to be in. It’s expensive and going up. When it does turn, as we think it will at some point, this is one of the longest bull runs in history and it can’t go forever – then we will be in the worst box. The key is to be aware of where we are to have a plan and to know when to take a risk off the table and not get your emotions involved and get too scared early or too greedy right now.

Michael Carlin

We are happy to share these charts and graphs – Steffan specifically speaking about the cape measures in different high valuations, that we have, and you can send us an email to: info@ hh-wm.com and we’re happy to share these items with you. So, you’re right in the valuations are tough, but there’s still good economic data out there. Wages and spending are key to the way our whole economy works.

From the point we are still a consumption-based economy. This is not going to change, and we need people working and earning more money, so they can spend more. We focus on wages and the stock market has exploded and done great since March of 2009, great in 2016, great 2017 and a great start in 2018. The wage increase really falls hat in hand when wages started to increase; that’s when the market really got a whole second leg to drive things forward. Just another positive fundamental wage growth. This helps middle class households all over the United States. Is this something that is going to continue to drive the market forward, and can we get excited about it? This is where we think valuation plays a part.

Steffan Dye

It’s wonderful for employees to have more money to spend. 70% gross product comes from consumer spending. You think you’re going to have a better GDP if you have more spending.

I saw something interesting this week from the Louisiana Federal Reserve Board. They are showing that employment change for those 55 and older since 2000 are more and more employed. 17 million more employed are 55 and older. At the same time in 2007 during the great financial crisis, those under 55 employed began to drop and started to recover in 2011. The gap between the two is wide. This shows that Americans are working longer, and younger Americans are having a hard time finding a job. The 55 and older group tends to spend less than the 55 and under group. This is something interesting to watch as we figure out how employment and wages are going to rise.

The concern I have about wages rising is the Central Banks are going to watch those wages rise and that’s where they tend to pull back on their balance sheets.

Michael Carlin

They raised the short rate they are expecting for this year. For interest rate increases.

Steffan Dye

They say we are going to reduce the amount of money in the system and that’s when the stock market could begin to wobble.

Michael Carlin

If we have time we can go back to this.

Let’s talk about more physical activity. Let’s talk about the Tax Cuts and Jobs Act. There were times in 2017 when we felt the market was so hopeful that it was going to happen, that it was rising in expectation of that event. For a good part of 2017, middle of the year and end of year, it felt like it wasn’t going to happen. Then it did in a big way. So, what we are seeing in the expectation is that the net cost at offering this individual and business tax reduction is a trillion and a half dollars expected cost to the U.S. government. There are hopes and expectations the CBO does progressive scoring where they hope they get economic growth to help offset some of that one and a half trillion dollars. What a shot in the arm that Tax Cuts and Jobs Act has provided the economy.

Steffan Dye

It’s hard to know if the market has priced in properly. Have they over priced in the benefit or underpriced in the benefit? More money in the economy is better. You see Apple making moves and noises about bringing back 250 billion.

Michael Carlin

My issue is that yes, we are going to repatriate these foreign dollars It would be one thing if we knew it would be creating jobs, building factories or paying dividends, but the expectations to many will be doing buy-backs and things that will be fairly invisible to economic growth. Good for shareholders, good for the stock market, but potentially not great for economic growth. If you’re the congressional budget office and must do this dynamic scoring to figure out with these hundreds of billions, potentially trillions, of dollars coming back from overseas what the economic impact is going to be, I would get more excited if there were more companies and there has been some talking about hiring, talking about building and growing. I haven’t seen as much as I like to.

Steffan Dye

I will be happy to see my after-tax income a little higher. I’ll get to keep a little bit of money. I’m happy about that part.

Michael Carlin

We’ll take anything we can get. The last economic data point is volatile. The measure there is how much the stock market is going up and down on a daily basis. There have been pockets and periods of times when, and we have great data we are going to share with you at the end of the podcast, we talk about conclusions which we will take a deeper dive into the volatility. But Steffan, the impound of volatility is very low. It can lull investors to sleep. I think.

Steffan Dye

It’s amazingly low and if you only looked back over a 12-month period, you would think the stock market only goes up. For 12 months in a row we’ve had a higher stock market price here in the United States every month. That’s only happened a few times in the history of the country. The only longer time was in 1958 to 1959 where it did it for 15 months, so a couple more months of this and it will be a record.

Michael Carlin

It lulls the investors to sleep thinking I can’t lose. I’m just going to keep putting money in the market and I’m not going to worry about it.

Steffan Dye

You see record inflows to equities and the people are very excited. It’s a fun time to be in the market.

Michael Carlin

Hopefully it’s a little bit of a nerve racking time too. We want to provide the realistic expectations for what to think about the market moving forward. Every market outlook for 11 years now, we use special breakouts, so we do talk about markets, fundamentals and things like that.

Why don’t we switch gears? Steffan, you had a decade and a half year career with one of the largest energy exploration companies in the United States. It would be great if we could talk about the rebound in oil prices. I think that would be a great special aspect and we’ll talk about today. For this quarter’s special we’ll do oil, some renewables and solar. Why don’t you spend a few minutes and tell us what you’ve seen in the oil market?

Steffan Dye

We could get stuck in oil prices for a long period of time. I think the oil story is really a technology story. For those of you who do not know what’s happened – in oil is two technologies converged to open a bunch of oil in the United States that was previously not accessible. In doing so, it changed the dynamics of oil prices across the world. Because oil is a global commodity, you must pay attention to what’s going on in the supply side and the demand side across the world. What you’ve seen is OPEC trying to control the price of oil. OPEC being the organization of petroleum exporting countries. It’s led by Saudi Arabia which is the largest producer and the most important member of OPEC; Russia has informally joined the coalition. They agree to limit or increase production to manipulate prices.

Right now, OPEC is saying that they’re going to continue to cut their production cost in 2018 and we are seeing oil prices rising and staying strong. We’ve seen oil prices drop from $105 dollars in July of 2014 down to a low of $26 dollars in February 2016. Then we’ve had a real run recently of lows of $45 dollars in the last years. I think most people think oil should be in a range between $40 to $60 dollars in the United States. There is a premium in Europe right now. The price of Brent Oil, as opposed to the West Texas Intermediate, is about $6 dollars higher. We think they will begin to converge in 2018.

Michael Carlin

Here is a question for you. Do you think that oil prices, being in the high 50s range where we are today – do you think it’s because of Saudi Arabia’s or OPEC, I should say – their words that they are going to cut, or do you think some of its demand? Or a combination?

Steffan Dye

I think demand has been high. Demand remains strong. Surprisingly, supply has been strong as well. The number of variables that influence the price of oil is astounding. We can focus on OPEC, we can focus on shale oil, but we still leave out many factors that are important that most people can’t see. The good thing to do going forward is to assume a $40 to 65 range. There is a possibility it could go up or down.

Michael Carlin

Because demands are fundamentally high and Saudi Arabia and OPEC are saying the right things about their supply side in terms of feeding the market.

Steffan Dye

The demand is strong and supply is strong. The supply is rising at a dramatic rate largely in the U.S. It’s due to the two technologies and the converge to make the shale. Natural gas, we are talking about energy. Go to a broad look at energy. I think it’s interesting the Energy Information Association does a short term outlook every quarter. The most recent outlooks say total fossil fuels production, which is oil, gas, coal and natural gas, in the United States will be the highest record in 2018 and will be the highest in 2019.

Most of the growth for the next two years is expected to come from the shale oil production that we talked about and from higher natural gas production. Natural gas, what you are really seeing is a shift to more natural gas uses; create electricity as coal becomes less and less preferred. We have so much natural gas and the same two technologies that converge to open oil did the same thing in gas just before. Fracking and lateral drilling – you can drill down and sideways to break the rocks up and it releases the gas.

Michael Carlin

We are going to have to do a podcast on fracking. So, the energy we see is not coming from coal; we see it coming off line more and more. One of the things I do is I translate that back into the stock market to see energy prices going up. How much is that going to continue to move the market higher? It wasn’t all that long ago in 2008 where energy companies, just in the S&P 500 alone, made up 15% or 17% of the S&P 500 were energy companies. Today energy companies only make up 5.8% S&P 500.

I put this information together to say high energy prices at one point were very important to the stock market and moving higher. Higher energy prices today have less of an impact, I think; it has lots to do with the S&P 500 isn’t made up of energy stocks the way it used to be.

Steffan Dye

It’s not going to impact the S&P as it would’ve in the past. The other thing we were talking about in oil prices is the U.S. dollar and usually the dollar when it rises oil prices will fall. They work opposite of each other. Interestingly, the dollar and oil rose at the same time. It’s an interesting time to see what happens with those two and how the market reacts.

Michael Carlin

It will be interesting how the market plays out. That linkage between high energy prices and high market, I just think partially broken as is explained by the amount of companies that make up that part of the S&P 500 index.

Let’s switch gears and talk a little bit about the renewables, the solar. I sit on a board for a large solar utility company here in Scottsdale, Arizona. I have a few perspectives on it. It’s increasingly important that we have this conversation because solar has created virtually more jobs by sector than any other part of the U.S. economy that I am aware of. Hundreds of thousands of high paying U.S. jobs have been created in that solar marketplace.

I was surprised to learn the tariff that was in Section 201 was approved yesterday. It’s surprising because the administration is charging a premium now for imported solar panels. There was a lot of fear and anxiety in and around the solar marketplace that this tariff was going to be crippling. That it was going to increase the price of solar panels to such a degree that it would make the cost of building the large utility projects across the United States that created so many jobs would make the cost so unreasonable. That’s been part of the whole solar story.

The reason that it’s come online is not because people have become so green. People like the idea of sun goes up, sun goes down and I don’t have to burn any to create energy. It’s the economics of it that I want to talk a minute or two with regards to solar that has made it so important to our acceptance and future use of it. Solar costs are down 80% since 2009. As technology improves and the cost of things go down and the better use of the solar panel. The amount of solar, as the costs go down 80% as of 2009, installed has gone up since. It proves the point that solar is working largely because the economics supports it.

Steffan Dye

This is an interesting topic to explore. If you look at the history of energy use, and there is a period where humans used wood energy and they built technology in England and other places to use that wood. Then we discovered coal as a species and decided to use it. There is more energy in coal. Then we switch to use oil. This had a lot more energy per unit of weight. Now we are switching again and in a transition to solar and wind renewables. My experience has been largely on the oil side as I raised nearly a billion dollars on offshore and in the Gulf of Mexico. A lot of my personal holdings are in oil and in the Gulf of Mexico. Your experience is on the new and I’m the old.

Michael Carlin

It’s a 2016 percent of global energy output; 2% of it was solar. At a reasonable rate of increase than what we are seeing moving forward, even including the tariff that was just put in place. By 2040, the International Energy Association, Oxford Club, Bloomberg and BP – they all assume that the numbers are going to be at 30% of global energy output will be from solar.

I look back at the fundamental cost and Lazard has a nice chart. The information is a little old, but it says here that the utility scale solar cost five cents per kilowatt hour and you compare that roof top solar. You say is it time for me to buy roof top solar? No, it’s still too expensive. At the time that this was printed by Lazard roof top solar was 18 cents more than triple the cost of big utility scale solar. I don’t think we will see a lot of roof top solar any time soon because of cost.

Wind on an unsubsidized basis is at six cents a kilowatt hour. Utility scale solar is at five cents. Right now, I can tell you that utility scale solar is at four cents. We have seen an improvement there. Compare it to natural gas, eight cents at peak natural gas; where natural gas is very expensive, natural gas was at 21 cents, coal 14 and nuclear 18 cents. Why would you look anywhere else for a cost solution that’s available?

Steffan Dye

I think you know the answer to that question. It has to do with established interest and the infrastructure that’s available. Transition is happening. We are moving to a solar and renewal powered footing in this economy and that’s good.

Michael Carlin

Have you seen there is a really good use of natural gas to power solar plants at night? It’s amazing the efficiency. Many thought it would be solar plus battery, but we are seeing that it’s solar and natural gas to create this 24 hour a day reliable energy source. This is less expensive.

In conclusion, we must wrap all of this up. We have unpacked U.S. economic data about wages and jobs, the economic moves that the government is making here and overseas in market performance. What everyone is looking for is direction. Would you like to start first?

Steffan Dye

What am I expecting? What am I hoping for? What should I be worried about? In the markets, which is what we care about the most, the global market will continue to do well. This is what I am expecting – 2.8 in the fourth quarter, so I’m expecting the same in the first quarter of this year. It’s a good number that’s sustainable.

What am I worried about? I worry about Central Bank liquidity at some point begin to dry up a little bit and the stock markets going from expensive in an uptrend to expensive in a down trend. I don’t think it will happen this quarter, but I have our antennae up.

Michael Carlin

I’m expecting something similar. Of all the economic data that is solid and all the consumer confidence that we talked about in jobs and wages, all those things seem to be improving. I believe we are going to see this market move forward. The economic data supports all this.

What I’m worried about is this last piece of data and the chart that I teased about ten minutes ago. Are we due for a correction chart? I don’t know. Here’s the data, 77 weeks since we’ve had a correction of 5%. That’s significant because we typically have it. This is data that goes back to 1928 to present. We typically have a 5% correction every fifth week. Well, it’s been 96 weeks since we’ve had a correction of 10%. We typically have that every 33 weeks. It’s been 445 weeks since we’ve had a correction of 20% or more. We usually have them every 127 weeks. So, what am I worried about is reversion to the mean. I’m worried about this bull market run that we’ve had – that’s the second longest ever – runs out of juice. Will this be due to the Fed pulling away the punchbowl, increasing interest rates four times this year because there is good economic data and it makes things a little tight and slows down economic growth? Is it possible that this tax cut relief, the fact that what we got was the last fiscal policy move that pushes our market higher? Is it the fact that everyone is talking about bitcoin and equities?

We are seeing a lot of signs of market top and this is the time to be cautious. Think big picture. We are not doomsayers by any means, but we are talking about how the market performs. Well, we both expect it to continue to move forward. We do see good times of economic recovery,

Steffan Dye

Mean reversion is prices have an average price over time an average of expensiveness or inexpensiveness. When prices go through average, they extend above or below; eventually they revert to the average. We are way above the averages right now. I think Michael is worried that everything will go back to average. Also, the valuations are above.

Michael Carlin

LeBron James’ average is 27 points over his whole career. That’s his average. If he has 39 points per game for a month. I don’t automatically believe he is a 39-point game scorer. I think at some point there that mean reversion and it goes back. Thanks for tuning in. This is Michael Carlin and Steffan Dye signing off.