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President & CEO
Masood Vojdani began his career in the financial services industry in 1981. From the outset, he was driven by the vision of a firm that was different from the industry status quo. At the heart... Full Bio
Did you hear the news this week? General Electric, one of the world’s oldest going concerns, was dropped from its august perch in the Dow Jones Industrial Average. That index of 30 companies will no longer include the only company still in business today that was a constituent member of the Dow Twelve – the companies Charles Dow fashioned into a market index back in 1896. GE will be replaced by Walgreens, which is probably not a bad idea since retail pharmacy is currently under-represented in the index (Wal-Mart being the only company in the heretofore 30 where you can get a prescription filled).
As with just about anything Dow-related, though, the news about GE and Walgreens matters more for stock market historians and storytellers than it does for actual investors.
A Quaint Relic
To the mind of the typical retail investor, “the Dow” is interchangeable with “the market.” Round number days on this index – when it, say, breaks 20,000 for the first time – are feted like national holidays in the financial media. When the stock market experienced a technical correction earlier this year, commentators were breathless with the report that the Dow had fallen by more points (1,179 to be exact) than ever before in its history.
None of which matters for any reason other than idle water cooler gossip. In fact, the media’s fixation on the Dow’s points loss on February 5 was not only pointless, but potentially harmful if it induced anyone to actually sell out in a panic. The percentage loss corresponding to that decline of 1,179 points was nowhere close to the all-time record loss of 22 percent, on October 19 1987.
Yes, it’s fun to study the Dow to gain a perspective on how the US economy has evolved over the last 122 years. It’s nice to arrive at cocktail parties armed with trivia like Distilling & Cattle Feeding or Standard Rope & Twine (two of the original twelve companies that didn’t have quite the staying power of GE). But that’s where the usefulness ends. Consider the fact that of today’s market-moving FAANG companies (Facebook, Amazon, Apple, Netflix and Google) only one – Apple – is represented in the Dow. Technology stocks make up about 25 percent of the total market capitalization of the S&P 500 (and an even greater percentage of the NASDAQ Composite). The tech names represented on the Dow – Apple, IBM, Cisco Systems, Microsoft and Visa – are not exactly unimportant, but they are less representative of the full spectrum of what is arguably the most influential sector of the US economy in 2018.
Price of Everything, Value of Nothing
The other major problem with the Dow, in addition to the somewhat arbitrary and backward-looking nature of the 30 constituent names, is the way the index’s performance is calculated. Whereas the S&P 500, NASDAQ and most other broad market indexes calculate performance based on market capitalization (number of shares outstanding times share price), the Dow is a price-based index. This means adding up all the share prices of the 30 stocks and dividing them by a divisor (which changes over time to reflect share splits, share dividends and the like).
The basic flaw in the price methodology is that it gives stocks with a higher price more impact on returns than stocks with a lower price. If Company A has a stock price of $100 and Company B has a stock price of $10, then Company A’s share price movements have a bigger impact on the index than those of Company B. But those raw share prices tell you absolutely nothing about the economics of either company. If Company A has 1,000 shares of stock outstanding and Company B has 10,000 shares of stock outstanding then both companies have the same market capitalization -- $100,000. In a market cap-weighted index like the S&P 500 their share price movements would have the same impact, not the skewed outcomes they produce on a price index like the Dow.
Here Today, Here Tomorrow
Of course, we do realize that all our carping about the Dow Jones Industrial Average will not stop it from being “the market” in the popular lexicon. Humans gonna be humans, after all. And that’s fine, as long as you make sure that your actual portfolio pays more attention to today’s economy than to the colorful past chapters of US stock market history. Now, there are times, of course, when the Dow will outperform the broader benchmarks, and there are times when it will underperform. As the chart below shows, right now is one of those times when it is underperforming – actually in negative territory for the year to date while both the S&P 500 and the NASDAQ Composite are in the black.
It’s a nice bit of history, but there’s no reason to have it in your portfolio. Exposure to large cap US stocks is best achieved through a broad market cap index like the S&P 500 or the Russell 1000. Adding other distinct asset classes like small caps, developed and emerging international equities can help achieve long term risk-adjusted return goals. That’s prudent diversification, to which the Dow is just a frivolous sideshow. A fun sideshow (hello, Nash Motors, inductee of 1932!), but a sideshow all the same.
Investors price a variety of assumptions into their asset valuation models every day, based on cyclical factors like interest rates and inflation expectations. Behind all these short term variables, though, is a more fundamental assumption about how the world works. That assumption is grounded in the primacy of what, for want of a better phrase, we call the “global technocracy.” As well it should be – the technocracy has survived largely intact since the Bretton Woods conference of 1944 that set the postwar world order.
But the global technocracy is in trouble, and we don’t really have a good playbook for mapping out scenarios involving their eclipse by other forces. This may prove to be interesting times – in the sense of that old Chinese proverb – for analysts trying to distill tectonic shifts in the macro world order into an informed model of likely asset price trends.
Saving the World, One Crisis At a Time
The global technocracy is made up of the policymakers – central bankers, finance ministers and their ilk – who can always be counted on to steer markets away from the shoals of peril back into calmer seas. They may not necessarily solve the problem of the day, but they can paper it over for a later day. Think of the Greek debt crisis and the various US debt ceiling debacles in recent years, and the bailout of the Long Term Capital Management hedge fund in the late 1990s. Back then we had the “Committee to Save the World” as Time magazine dubbed the triumvirate of Alan Greenspan, Robert Rubin and Lawrence Summers. In our present day we have Mario “Whatever It Takes” Draghi and of course the now-technocrat emeriti team of Ben Bernanke and Janet Yellen who got us safely through the narrows of Scylla and Charybdis and back to growth after the Great Recession.
Stop Us If You’ve Heard This One Before
“They won’t pay their fair share!” “It’s time to put America, and working Americans, first!” “No more bad trade deals!” Sounds familiar, right? As in literally every day of life since January 2017. Please don’t think of this as anything unusual or unprecedented. Think, instead, of 1920. The Great War had ended, and our European allies, battered and destitute, owed America $10 billion in reparations for war debts (about $152 billion in present-day terms). World War I put an end to a glorious 40-year era of global technocracy, led by Great Britain.
With Britain severely weakened, the mantle of leadership now fell to the US. The major private investment interests of the day, led by the likes of J.P. Morgan and A.J. Drexel – card-carrying members of the global technocracy – saw the war debts as an albatross that would impede the ability of their European trading partners to return to commercial viability, and they argued for cancelling them. Their arguments – and those of the Europeans themselves – fell on deaf ears in Washington. The Republican Party that came to power in 1920 was highly protectionist and inclined to…well, put America first. Not only did the US insist on full reparation of war debts, but Congress enacted highly punitive protectionist tariffs in 1921 and 1922. They would follow this, of course, with the extreme measures of the Smoot-Hawley tariffs in 1930.
The global technocracy was out. Narrow-interest protectionism was in. How did that work out?
A Splendid Little Decade, Until…
Actually, it worked out splendidly…for quite a number of years. That decade, of course, went down in history as the “Roaring Twenties.” It was an era of rapid technological advancement. The modern production-line factory came of age. Radio and wireless communications made RCA an early prototype for dot-com and then “FAANG” mania. Retail outlets and catalogue merchandisers such as Sears and Woolworth’s streamlined their business models. Prosperity abounded.
It all came to a dismal end, of course, with the 1929 market crash and the Great Depression. America’s aggressive economic stance against its allies (“trench warfare by other means” as the cynics of the day termed it) hindered reconstruction in Europe and left a leadership vacuum all too happily filled by opportunistic political extremists on the Continent. It would take another war, even more brutal and destructive than the first, for America to willingly accept its role as economic superpower and de facto head of the global technocracy.
It’s All About the Timing
The moral of this story is quite simple. While we may indeed be on the cusp of another tectonic shift in world affairs – in which narrowly partisan self-interest once again pushes the global technocracy off center stage – there is no real playbook to instruct as to how and when asset markets will react accordingly. A thoughtful investor in 1920 would have had excellent arguments, based on the data available at the time, to go all cash. That investor would have been right…nine years and 240 percent of cumulative stock price appreciation later.
It’s all about the timing. In the absence of a good playbook, investors and prognosticators are likely to learn just how tricky that can be. Think about this, though, at those barbeques this summer when some know-it-all tries to tell you that the sky is falling and it’s time to get out. Or that you should double down, because we’re about to embark on the most prosperous age ever known to humankind. “If X, then Y” is how the pundits like to spin their arguments into gold. The more salient formulation, though, is “If X, WHEN Y?” And that’s a question with an exceedingly elusive answer.
At the beginning of this year we foresaw the potential for a spike in volatility. For awhile back in February and March that looked like a prescient call. Now…maybe not so much. As the predictable humidity settles into the Potomac region it would seem that the only high-octane energy around here is coming from DC’s long-suffering sports fans, celebrating their hockey team’s recent Stanley Cup victory (go Caps!). Risk asset markets, on the other hand, would appear…well, not as risky as they did a couple months back. The chart below shows the CBOE VIX index, a popular measure of market risk, alongside the S&P 500 over the past two years:
Source: MVF Research, FactSet
As we have noted in other commentaries the VIX, as a tradable entity itself, does not necessarily portray an accurate picture of market risk, particularly those Andean spikes that appear out of nowhere when algorithms hit their tripwires and summon forth the legions of trader-bots. But stock indexes appear becalmed as well when looking at internal volatility measures like standard deviation. We’re not quite yet in the valley of last year’s historically somnolent risk levels – but we seem headed that way and not too far off.
Don’t Grumble, Give a Whistle
Why the complacency? Even as we write this, the vaunted group of developed economies that call themselves the G-7 appear to be having a serious failure to communicate. Trade war rhetoric has stepped up following last week’s imposition of steel and aluminum tariffs by the US on its supposed allies including Canada and the EU. Italy, as noted in our commentary last week, is grappling with a political crisis and potentially unstable financial situation. Geopolitics are on the front page with the US-North Korea summit in Singapore fast approaching, to say nothing of the uncertainty around the Iran nuclear deal, the North Atlantic Free Trade Agreement (NAFTA), and growing evidence of China seeking to extend its economic clout in Southeast Asia, Africa and Latin America. There are headlines aplenty (even ones that don’t have to do with Trump’s Twitter account or the musings of some or other comedian) that could keep investors fidgety – and yet they calmly whistle past the bad news on the way to the sunny climes of the volatility valley. The latest bout of buying has lifted the S&P 500 comfortably above the 50-day moving average resistance level, as the above chart shows.
Nothing Else Matters (For Now, Anyway)
Actually, there is a reasonable justification for this midyear complacency, which is that for all the daily noise, not a whole lot has really changed in the macro picture. And what has changed – a little more inflation, a lot more growth in corporate sales and earnings – has largely been benign or downright positive. The tax cuts enacted at the end of last year may have a deleterious effect on the deficit, but such effect will likely not be felt for several years (“several years” being roughly equivalent to “an eternity” in Wall Street-speak). The trade war, should it come to pass, will also likely tend to have a gradual rather than an immediate effect, particularly on the domestic economy.
As for geopolitics – well, the market is extremely proficient in ignoring geopolitical concerns until they actually happen. That’s not a recent phenomenon. British merchant banks were happily extending loans to their German clients in the summer of 1914, even after the assassination of Archduke Ferdinand in Sarajevo. The Great Trade War of 2018, so far anyway, is not conjuring up images of the Schlieffen Plan or entrenched battle lines along the Marne.
The S&P 500 is up about 3.5 percent (in simple price terms) for the year to date. Earnings per share for the companies that make up the index are projected to grow at around 20 percent for the full year, with top line sales coming in at a robust 7.5 percent. That’s pretty agreeable math, and a decent reason to think that a fairly low-vol summer may be in store.
2011, 2012, 2015…ah, memories of summertime Eurozone crises past. On the cusp of the summer of ’18 it would appear not entirely unreasonable to imagine that we are due for another languid spell of troubled waters across the Atlantic. Political dysfunction in the southern periphery was on full display this week, first with Italy’s fumbling attempt to form a new government and then with a no-confidence vote shoving Spanish PM Mariano Rajoy out of office in favor of Socialist Party leader Pedro Sanchez. Word is that Rajoy sat out the parliamentary hearings leading to his ouster, choosing to spend those eight hours in a Madrid restaurant instead. Respect.
Oh, and the US went ahead and imposed steel and aluminum tariffs on the EU, leading EU trade commissioner Cecilia Malmstrom to pronounce a “closed door” on EU-US trade liberalization talks. Abandon hope, ye bourbon drinkers of Europe. The euro continued its slide while investors hugged onto German Bunds like a Steiff bear, illustrated in the charts below.
The big drama this week, of course, came courtesy of Italian president Sergio Mattarella as he gave a Roman thumbs-down to the cabinet submitted by the recent populist partnership of the Five Star Movement and Northern League (see here for our analysis last month of the implications of this partnership). The move caught investors by surprise and Italian bond yields soared (the blue line in the leftmost chart above).
It may seem counterintuitive that Mattarella’s move sparked a negative market reaction. After all, his opposition to the cabinet slate was focused on the proposed finance minister Paolo Savona, an outspoken critic of the single currency union. The resulting impasse with the FSM/League coalition led to a proposed caretaker government led by Carlo Cottarelli, a former IMF official. That sounds awfully market-friendly…but no, investors read this as a resurgence of the “in or out” question that last reared its head with the Greek financial crisis of July 2015. The thinking was that Mattarella’s technocratic move would give a new tailwind to the Northern League (which indeed has seen a sizable bump in the polls this week) and could result in a more decisive victory for the “out” faction in another round of elections this fall. Suddenly “Quitaly” was the new “Brexit.”
Trouble Ahead, Trouble Behind
The Mattarella tempest resolved itself just in time for markets to breathe a tempered sigh of relief and not pay attention to the no-confidence vote brewing over in Spain. The FSM/League coalition came back with an “acceptable” candidate for finance minister, Giovanni Tria (a political economy professor), Mattarella gave the green light, and all appears ready to proceed apace. Italian assets recovered some lost ground. The can appears safely kicked down the road once again, and now we can all relax and start watching the World Cup, right?
Perhaps not. There are challenges aplenty for this new, not entirely stable coalition government in Italy – on domestic debt levels, on immigration, and – yes – on the general relationship with Brussels, which is hardly amicable to begin with. And while observers don’t see much in the way of market ripples coming from the recent events in Spain, the fact remains that the no-confidence vote there came about due to revelations of political corruption and a slush fund operated by senior members of former PM Rajoy’s Popular Party – another blow to Establishment credibility. The new government led by the Socialists includes an unwieldly array of coalition partners including nationalist Basque and Catalonian factions and the far-left Podemos Party – so there is hardly a unifying ideology there.
In fact, very little about Europe’s political environment looks stable. Nationalist and borderline fascist blocs control much of the eastern periphery of the EU, Germany’s “grand coalition” is struggling, and all the while thorny issues with Brexit persist on the western front. The economy has reverted to slow-growth mode, the ECB is trying to navigate its way out of its monetary stimulus obligations, and now Brussels needs to rally the troops around a united response to those ill-advised US tariffs.
It may be summertime, but the living would appear to be anything but easy.
It’s a very good thing for US large cap equity investors that consumer staples companies make up only 7.4 percent of the S&P 500’s total market cap, while the tech sector accounts for 25.4% of the index. The chart below shows why.
Tech stocks have outperformed the market for most of the year to date, while consumer staples have experienced a miserable couple of quarters. Here’s where those market cap discrepancies really matter: the fact that tech stocks make up a quarter of the total index means that their performance “counts” for more (we explained this in one of our commentaries a couple months ago). So, even though the magnitude of underperformance for consumer staples is greater than that of tech’s outperformance, the heavyweight sector pulls up the broad market (the dotted red line represents the total S&P 500) and, for the moment anyway, keeps it in positive territory.
So what’s going on with consumer staples? By one yardstick – market volatility – the sector might have been expected to outperform over the past couple months. Consumer staples has long been regarded as a defensive sector, i.e. one which tends to do better when investors get jittery. The logic is easy to follow. A volatile market signals uncertainty about the economy, which in turn leads to households tightening their budgets. So things like expensive vacations and designer labels (which would show up in the consumer discretionary sector) get the axe, but folks still have to buy toothpaste and breakfast cereal (which are manufactured, distributed and retailed by consumer staples companies like General Mills, Sysco and Costco).
But two technical corrections of more than 10 percent didn’t send investors flocking into defensive stocks. Other traditional defensives, such as utilities, also fared relatively poorly during this period. There is one driving variable common to a variety of traditional defensives, which is rising interest rates. But there are a couple others that are particularly relevant to the woes in consumer staples.
Hard Times for Dividend Aristocrats
The connection between interest rates and defensive stocks is fairly straightforward. These stocks tend to have higher dividend payouts than more growth-oriented shares. For example, the average dividend yield in the consumer staples sector is around 3.1 percent, compared to an average yield of 1.8 percent for the S&P 500 as a whole. The relative attraction of dividends diminishes when income yields on high quality fixed income securities (like Treasury bonds) increase. This relationship is then exaggerated to an even greater extent by the abundance of algorithmic trading strategies that mindlessly key off small changes in rates, sending cascades of buy and sell orders beyond what many would see as the actual fundamental value shift.
The Worst of Times
Two other variables with a particularly pernicious effect on consumer goods companies are inflation and changing demand patterns. These variables are closely related. While inflation is still relatively low by historical standards, it has ticked up in recent months. Cost inflation – basically, higher input costs for the raw materials and the labor that go into the manufacture of consumer goods – puts downward pressure on profit margins. If companies can pass those cost increases on down the value chain – i.e. from manufacturer to distributor to retailer to end consumer – then they can contain the effect of cost inflation. But that means, ultimately, having consumers willing to pay up for the staple items they buy from week to week. And this is where that second variable – demand patterns – comes into play.
Simply put, consumers have become pickier about what they buy and how they buy, and they have a far greater spectrum of choices from which to curate their own particular needs and preferences. Time was, the weekly shopping cart was pretty predictable in terms of the packaged goods with which Mom and Dad filled it up, and also where the shelves containing those goods were located. Established brands carried a premium that was a predictable source of value for the likes of Procter & Gamble, Coca-Cola or Kraft Foods. That brand premium value hasn’t disappeared – but it has become diluted through an often bewildering assortment of products, categories and messaging. The emotional tie between a consumer and a favorite brand dissipates when the products and the messaging are constantly changing, popping into and out of existence like quantum matter.
That dynamic makes it much harder, in turn, for companies to convince their customers to accept the passing on of cost inflation. The logical outcome is lower margins, which have been the wet blanket souring quarterly earnings calls this year. Unfortunately for the companies in this sector, these are not problems that are likely to disappear with the next turn in the business cycle. Even the elite leaders, such as P&G and Unilever, have daunting challenges ahead as they try to leverage their storied pasts into the unforgiving environment of today.