Mortgage Refi Cash Outs On The Rise

Mortgage Market Review

Nearly half of mortgage borrowers in the first quarter of 2017 opted for a cash out option when refinancing. The amount of cash outs is at the highest since the 4th quarter of 2008, when the financial crisis was in motion.

Cash outs were tremendously popular during the housing boom when almost 90% of all refinancing included a cash out option. Cash outs as a percentage of total refis dropped considerably to 12% in 2012 following new rules and regulations.

Also fueling recent cash outs is the rise in housing values that allows homeowners to extract a portion of their equity as cash. Before new regulations, cash outs were available on higher percentages of home values, whereas rules today limit cash outs to much lower loan to value loans.


Sources: Federal Reserve, Federal Housing Finance Agency

Another Bear Market?

Global Financial Private Capital
Thought for the Week

SYNOPSIS

  • This week, oil fell into its sixth bear market in the last four years.

  • Oil has been a big story and market-mover since Saudi Arabia started a price war back in 2014.

  • Saudi Arabia will regret the day they started this price war.

BEAR MARKET

This week, oil fell into its sixth bear market in the last four years. A bear market is defined as a decline of 20% or more in price since a recent peak, and there are few things the financial media loves more than a bear market. Hence, this news made the front page and consumed hours of live coverage by the networks.

Oil has been a big story and market-mover since Saudi Arabia started a price war back in mid-2014. Back then, oil was trading in triple digits, and the Kingdom was concerned about losing market share to the energy revolution that was well underway in the U.S.

Their goal was simple - cut prices to attract more business and cause high-cost U.S. producers to go under. Saudi Arabia has one of the lowest production costs in the world, so they felt that they could withstand a prolonged period of low prices. Once the U.S. producers left the market, they would then raise prices to regain their old profits.

This is a classic competitive strategy ploy attempted in nearly every industry.  For example, imagine an established chain of ice cream stores that is large enough to buy supplies in bulk at a cheaper cost and pay lower rents because leases were signed several years ago.

Then one day, a small competitor opens down the street from one of its locations. The incumbent decides to kill off the competition by dropping its price for ice cream to a level that cannot be matched by smaller stores. Eventually, the challenger goes out of business, and the incumbent restores prices back to their original level. The problem for Saudi Arabia is that their master plan has not unfolded as they had hoped, but before we discuss the implications of this new bear market, it’s important to understand why this price war will end up being a mistake of epic proportions.

DARWINISM IN BUSINESS

Business is a lot like the wild, where only the strongest survive.  Prior to Saudi Arabia’s price war, oil producers were making a killing because nearly all known oil reserves were profitable with crude selling above $100/barrel.

An ample food supply attracts predators, and big profits do the same for capitalists.  New oil companies were being formed overnight, and they all were so anxious to grow as fast as possible that most threw financial discipline out the door.  As the price war began and times got tough, natural selection became the only force that could bring harmony back to the sector.

The strong were those with disciplined managers, diverse operations, and relatively sound financials. These companies represented the smarter and healthier gene pool in the wild. The weak were those who took on way too much debt, did not manage costs properly and had bad management teams. These companies represented an injured buffalo in an ecosystem that offers no protection from the imminent dangers that hunt them.

Ultimately, the weak cannot survive. The cruelty pervasive throughout financial markets does not allow them to remain in business.  Some filed for bankruptcy and others got acquired by the strong, but in any event, they had to go before order could be restored.  Simply put, the price war ultimately benefitted the U.S. energy sector because it thinned out the herd and forced survivors to become stronger.

HUGE MISTAKE

Fast forward to today, and Saudi Arabia is starting to realize that Darwinism and capitalism are inextricably linked, and there is no country in the world that thrives on capitalism more than the U.S.  Since the U.S. energy revolution began, the strong companies have been reinvesting billions back into their businesses to lower their cost of production.  Rigs are now run by computers, and costs have been cut to the point where they have not only learned how to survive with cheap oil but become profitable.

Data supports this conclusion. Drilling in the U.S. has been rising this year, and a company is not going to increase production if they cannot charge more for a product than it costs to produce it. But what is most compelling about this new bear market is the impact to the Organization of the Petroleum Exporting Countries (OPEC) cartel.  Almost a year ago, OPEC agreed to cut production to boost the price of oil higher.  Saudi Arabia and many other members’ economies are heavily reliant on oil revenues, and the pain experienced by the 70%+ drop in the price of oil became too much to bear.

The fact that oil is now moving opposite to the wishes of the cartel is an incredible sign that the cartel that has controlled the price of oil for decades appears to have finally lost their grip. This will be a very big deal for the rest of the world because now the market will decide the price rather than a small group of self-interested and complacent governments.

IMPLICATIONS FOR INVESTORS

Saudi Arabia could have avoided a lot of pain and misery if they had just spent a few hours reading through economic history to assess the success rate of price wars.  The short version is that they almost never work.  The irony behind their decision is that they have done nothing but better position our economy for the long run.  The absolute best possible outcome for the U.S. is an extended period of cheap energy. We pay less at the pump, and companies here pay less for their input costs.

If the bear market deepens further, we may see some equity market volatility, but it will not last. What will persist are the continued efforts of U.S. producers as they drive down their production costs further. The loser will be OPEC because cutting prices is easy, but raising them can be incredibly difficult. This is a lesson they are learning right now, and they will most likely pay the consequences that come from failing to diversify their economy away from oil.

The bottom line is that not all bear markets are bad, and we should be thanking Saudi Arabia for thinning out the herd rather than concerning ourselves over periodic equity market volatility.

 

This commentary is not intended as investment advice or an investment recommendation. It is solely the opinion of our investment managers at the time of writing. Nothing in the commentary should be construed as a solicitation to buy or sell securities. Past performance is no indication of future performance. Liquid securities, such as those held within DIAS portfolios, can fall in value. Sincerely,

China Buying U.S. Treasuries Again

Global Fixed Income

Currently valued at over $13 trillion, the U.S. Treasury Bond market continues to be the world’s largest and most liquid bond market, attracting capital from foreign central banks seeking safety and stability.

China-Tsy-Holdings.jpg

Federal Reserve data as of May17 shows that foreign central banks held nearly $3 trillion of the $13 trillion Treasury market, an increase of over $60 billion since the beginning of the year. Of the various foreign buyers, China’s central bank has increased its Treasury holdings the most by $29 billion to a total of $1.08 trillion. China is currently the second largest holder of Treasuries, with Japan the largest holder.

A reversal in the U.S. dollar has also helped propel buying by foreigners in order to help stabilize their local country currencies. U.S. Treasuries continue to offer higher yields than other developed country debt such as Japan or Germany, attracting yield seekers.

For the first time in almost 30 years, China’s government debt rating was lowered in May by one of the major credit reporting agencies, Moody’s. Such a move could diminish China’s ability to borrow funds from domestic and foreign investors.


Source: Federal Reserve Foreign Holdings Report, Moody’s

 

Words to Live By

Global Financial Private Capital
Thought for the Week

SYNOPSIS

  • The best part of being a professional investor is the opportunity to learn something new every day.
  • Investors are wrong far more times than they are right, so it’s important to view every hit or miss as a learning exercise.
  • Here are ten lesser-known quotes that have helped guide my investment philosophy and decision-making process over the years.

LEARNING FROM OTHERS

The best part of being a professional investor is the opportunity to learn something new every day. It may be cliché, but the brain truly is a muscle that must be used regularly or else it risks atrophy. Below are ten quotes from various individuals who have shaped the way I view not just investing but also other facets of my life where logic and reasoning are critical to success. Some of the names will be quickly recognized, but most will not.

“If you can’t explain it to a six-year-old, you don’t understand it yourself” - Albert Einstein

No matter how complicated and/or intimidating the world of finance and investing may seem, nearly every concept can be explained. Therefore, be extremely careful around any investor who tries to impress or confuse you with financial jargon. Best case scenario is they are showing off, but more likely than not, they have no idea what they are talking about.

“I would rather be rich than right” - Nelson Peltz

I attended an investment workshop a while back and was privileged to hear Nelson Peltz speak to our group about his investment in DuPont. Mr. Peltz is a legendary investor who takes a long-term view in his holdings and has been incredibly successful.

This quote was so powerful to me because it sums up what this business is all about. To be successful, we must recognize that we will be wrong far more times than right. Check egos and emotions at the door, view mistakes as learning exercises, and be happy when proven wrong because it most likely just saved you from losing a lot of money.

“There are three types of lies – lies, damned lies, and statistics” - Mark Twain

Although statistics are powerful tools to help us recognize relationships, they mean nothing until properly vetted to ensure authenticity. Investors often succumb to the dangers hidden within statistics because they carry very powerful psychological triggers. It’s human nature to want to believe statistics on face value, and often the work required to support or disprove a relationship is either daunting or deemed irrelevant given the observed strength in the relationship.

By far, the most egregious abuser of statistics is the media. Think about how many statistics are quoted during nightly news broadcasts on television. Then think about how few of these figures are broken down to show how the data was gathered and/or analyzed. When it comes to statistics, my rule is simple. I consider them to be guilty until proven innocent.

“Wall Street indexes predicted nine out of the last five recessions” - Paul Samuelson

This well-regarded economist could not have summed up the true predictive nature of the stock market any better. Admittedly, the stock market has fallen prior to every recession going back to 1900, but it has been wrong more times than right.

Equities are anticipatory but they do not track the economy in lock step and often leave us with erroneous predictions. Focus on the direction of the economy rather than daily moves in the stock market. Emotions rule the short-term, and analyzing/ predicting emotions is impossible.

“In my whole life, I have known no wise people (over a broad subject matter area) who didn’t read all the time – none, zero.” - Charlie Munger

Google “Charlie Munger quotes” and spend some time reading through the results. His ability to sum up situations in a matter of words, albeit in a very blunt manner, is truly entertaining but more important educational. Not too long ago, the challenge for individual investors was gaining access to information that would enable them to make informed decisions on how to invest their savings. Wall Street used to be the gatekeeper to the research that investors desperately needed, and they only sold to big institutions who paid several million dollars each year to obtain.

Fast forward the clock to today, and thanks to the advent of the internet and regulation, there is now so much content available to investors that the challenge has become knowing how to find the information that matters. But it is out there. I dedicate the first few hours of every morning to reading from a wide gamut of sources because there are so many smart people out there these days who write for free, and I always feel a little smarter come lunchtime when I read from these experts in their respective fields.

“Be very careful when demand creates supply” - I don’t remember

I heard this from one of my instructors during a training program at the first firm to hire me on Wall Street. This quote taught me that booms and busts will exist until the end of time, and the two drivers of any cycle are always supply and demand. For example, take a housing market that is so hot that prices are rising close to double-digits. The opportunity to profit attracts builders to this market to create a new supply of homes. The problem is that builders get too greedy and overbuild, resulting in a lot of unsold homes.

Builders need to reduce their excess inventory or else it creates a financial burden on their company. Therefore, one builder decides to cut its prices to lure demand, which subsequently causes the other builders to do the same until prices crash.

The lesson learned here is to always have an idea where we are in any cycle, whether it be housing, stocks, energy, etc. Once supply begins to rise as it meets the beckoning call of excess demand, it’s time to start planning an exit strategy.

“Something that everyone knows isn’t worth knowing” - Bernard Baruch

Financial markets are comprised of assets whose prices are also driven by supply and demand. Prices rise when demand increases, and demand is fueled by information and analysis used by investors. If thousands of professional investors are taking this information and using it to buy/sell stocks, then we must assume that all available information has already been incorporated into asset prices in one way or the other.

Hence, the next time you read the Wall Street Journal over morning coffee or thumb through a three-month-old copy of Fortune Magazine while waiting to get your hair cut, just remember that this information is already baked into stock prices. It’s ok to still read them, but they should not be used as the reason to purchase whatever stock is being discussed. For an investor to believe that they have an information “edge” versus the competition, it must truly be something that other investors cannot access or else it will have already been considered.

“Three simple rules will explain 99% of human behavior: (1) Most people don’t think, (2) Some people are just jerks, and (3) Everyone is selling something” - Brett Arends, Columnist for MarketWatch

Rarely do I come across something so simple yet so powerful (particularly the third point). Since fear mongers never manage any real amount of money, they have chosen to get rich by getting people to sign up for their newsletter, buy their book, and pay for whatever other garbage they are trying to sell to those who need real financial advice.

Recessions happen, stocks lose investors’ money, and economies collapse under too much debt. But they don’t happen that often, and those who make such predictions carry no weight with me unless they can show me a time in the past where they made a bullish call and was ultimately correct. Only then can I consider them to be impartial.

What makes matters worse is that eventually one of these clowns will get lucky. The market will drop for some reason, and they will take their requisite “victory lap” around the media circuit to tell you why their system worked once again (even if the market decline occurred for reasons exogenous to their thesis). As the saying goes, “A broken clock is right twice a day.”

The world does not end all that often, and those who preach it are predators that have only one objective in mind, and that is to grow the size of their wallet.

“The real value of historical record is as a gauge of risk, not return” - William Bernstein

Mr. Bernstein is without a doubt one of the best writers and financial minds of our time, and his seminal masterpiece, The Four Pillars of Investing, is a mandatory read for any aspiring investor. History may not repeat itself exactly, but often it gives us a pretty good idea of how bad it can get. Knowing how to spot bubbles and when asset prices detach from reality can save investors from life-altering mistakes.

In April 2000, right around the time the dot-com bubble burst, here are just a few of the companies that were trading at valuations that look like typos:

  • Terra Networks selling at 1,200 times sales
  • Akamai Technologies selling at 3,700 times sales
  • Telocity selling at 5,200 times sales

For scale, even the most egregiously expensive growth stock in today’s market sells for 20x or maybe 30x sales. A more realistic valuation for a growth company is closer to 3x-5x sales, and even this range could be debated amongst conservative investors. Oh, and none of these companies had any earnings.

We all know how this story ended, so the next time you look to history as a guide, focus more on what it can tell you about the risk rather than the return. As Sir John Templeton famously said, “The four most expensive words in the English language are, ‘This time it’s different’.”

“The stock market is a giant distraction to the business of investing” - John C. Bogle

I constantly get asked the same two questions by both the media looking for a story and day traders looking for an edge. The first is what I think is driving the market at any given moment, and the second is what I think the market is going to do over the next 6-12 months.

My answer is always the same to both, which is I have no clue, and if I did, I would not be answering questions from reporters. Instead, I would be shopping for an island because what’s the point of having a crystal ball if you can’t use it to make enough money to establish residency in your own utopian state?

Think about the stock market this way. If emotions dominate the short-term movements in stock prices, and emotions are viruses to investing, then trying to understand what is driving the stock market on a daily, weekly, or monthly basis only adds unnecessary risk. There is simply no upside because any decisions based off such analysis will result in being either lucky or wrong.

That being said, I still watch the market closely because stocks go on sale all the time, and I love a bargain. A stock will often fall for unknown reasons while the fundamentals stay intact. Emotions cannot be analyzed but fundamentals can, and when these opportunities present themselves, it’s fun to profit on the fear and panic of others.

The bottom line is that this business is about managing risk rather than taking risk, and spending time agonizing over why the market is doing whatever it is doing or where it is going adds zero value.

Sincerely,

 

Credit Scores On The Rise For Americans

Consumer Finance

Higher scores lead to more available credit as consumers tend to receive more financing offers and promotions. Eight years after the financial crisis, consumers that suffered bankruptcies and repossession are seeing their credit scores improve. Theoretically, as credit scores increase, consumer expenditures also increase, but some believe it might be different this time. More favorable and higher credit scores are usually held by older consumers, who actually spend less as they enter retirement and empty nester years.

 

The onslaught of lower rates for over eight years now has also buffered consumers with the help of lower interest payments and more going towards paying down principal balances.

Sources: Fair Issac, Experian, Equifax, TransUnion

The Evolution of Bitcoin

Market Facts

An emerging form of digital currency has received tremendous media coverage this past month, Bitcoin, which is essentially virtual money that is traded digitally by exchanges. Bitcoins can only be purchased and sold with legitimate currency, such as dollars or euros, making it available worldwide. The total estimated value of Bitcoins worldwide as of May 30, 2017, is over 36 billion dollars.

Bitcoins exist as software, not physical currency, and are not regulated by any country or banking authority. Even though U.S. Senate hearings disclosed that Bitcoin could be a means of exchange, it gave no assurance that it would actually become an accepted medium of exchange. Government regulations would need to be created and then enforced in order for Bitcoin to become accepted by other government entities. The currency can be traded without being tracked, thus raising the potential for illicit activity, such as involving weapons, drugs, and prostitution. Bitcoins are not illegal, but it is also not legally recognized by governments as a currency.

Since the beginning of 2017, the total market value of Bitcoins have risen over 20 billion dollars, more than doubling since January 1 2017.  

Some believe that the price appreciation of Bitcoin has been a result of speculation and hasn’t been used as a store of value or as a medium of exchange to any extent. Some compare Bitcoin to the tulip craze in Holland of 1637, when speculators pushed the price of tulip bulbs to incredible levels, followed then by a collapse in the tulip bulb market.

Bitcoin has surged on speculation that perhaps one day digital money will eventually become a legitimate global currency and even replacing currencies from certain countries.

Bitcoins are mined by powerful computers that calculate complex, mathematical functions. Total Bitcoin quantity is capped at 21 million and currently there are about 12 million that exist worldwide. Circulating physical coins only represent Bitcoin and are not a store of value as is legitimate currency.

The growing mobile payment industry could be a big benefactor to the acceptance of Bitcoin as new and creative applications are being devised to accept digital currency. Bitcoin transactions are very popular among mobile users, where rather than using a credit card or cash to make a purchase, all you’d need is your phone.

Bitcoins emerged in 2008 designed by a programmer or group of programmers under the name of Nakamoto, whose real identity remains unknown. New Bitcoins can only be created by solving complex math problems embedded in the currency keeping total growth limited.

In 2014, the value of Bitcoins fell by over fifty percent following remarks by China and Norway to not recognize the digital currency as legal tender. The government of Norway ruled that Bitcoin does not qualify as real currency but rather qualifies as an asset, producing taxable capital gains. Norway said that Bitcoins don’t fall under the normal definition of money or currency.

More and more nations have been taking an official stance as the popularity of Bitcoins has evolved. The European Banking Authority has warned about the risks of trading digital money and being subject to losses where consumers are not protected by any government entity or authority.

As digital currency evolves, some believe that it will eventually be accepted as a legitimate currency. But for the time being, others believe that its time hasn’t arrived yet. Various studies have recently emerged with different opinions, such as a Stern School of Business study conducted by David Yermack, which concluded that Bitcoin behaves more like a speculative investment than a currency and has no currency attributes at all.


Sources:          Bloomberg, Reuters

 

 

How to Help the Next Generation Plan for Retirement

Global Financial Private Capitol
Thought for the Week

SYNOPSIS

  • Retirement planning has become far more complicated for the younger generation relative to when current retirees first got started.

  • Here are some tips to start preparing today for markets tomorrow that will help them navigate the complexities that they will most likely face.

  • Disciplined investing can build a nice nest egg over time, but true financial freedom only comes when one accumulates money without fear of losing it.

OH, TO BE YOUNG AGAIN

Imagine starting over in your 20s, armed with what you know now. There would be no limit to what you could accomplish with decades of experience on your side.

Until scientists find a way to turn back the clock, the next best thing you can do is offer advice to the younger generation, particularly your grandchildren, so that they can avoid the pitfalls that only experience could help them navigate safely.

Many of the rules have not changed: don’t spend too much money, don’t take on too much debt, and always plan for a rainy day. Continue to reinforce these concepts in the same manner your parents and grandparents did for you.

But just as cars and computers have grown in intricacy over the years, so has the process of planning for retirement. Low interest rates, the impending extinction of pension funds, and increasingly complex financial markets require a far more sophisticated plan going forward.

You can help your grandchildren navigate these complexities by instilling upon them the importance of not just saving, but also investing by following these ten simple rules:

  1. Invest in Equities: Recent grads should be 100% invested in stocks for three reasons. First, equities have delivered an average annual return of 10%, which is the largest of any major asset class. Second, this cohort has a long time horizon, so if the market were to experience another dramatic selloff, they would have the time to build back any paper losses. Third, the effects of compounding will amplify returns over time.

  2. Buy Index Funds: Active management of a stock portfolio requires skill, education, and experience. Younger investors have none of these, and those who try will be doing nothing more than speculating. Only buy low-cost index funds that track major indexes.

    ... true financial freedom only comes when one accumulates money without fear of losing it.

  3. Never Buy Company Stock: Tell them to avoid the temptation to invest in their employer’s stock. They may think that being an employee gives them an “edge,” but it doesn’t and never will unless their title begins with a “C” (CEO, CFO, etc.).

  4. Contribute Monthly: Tell them to maximize 401(k) contributions to the point where an employer will match. Think of this as “free money” deposited automatically with every paycheck. Long-term investors ignore entry prices and never try to time buying. They invest monthly, no matter what the short-term trend in the equity market may indicate.

  5. Buy into Panic: If the stock market sells off by 8% over any given month, take whatever excess cash and buy the dip. Only use excess cash, which is cash above and beyond what is needed to pay bills. Make this a rule and systematic. No matter what, keep to this strategy. If there is no excess cash then wait for the next dip.

  6. Establish a Roth IRA: Taxes are only going one direction, so recent grads should set up Roth IRAs before their incomes exceed the legal limit for these highly advantageous retirement accounts. Paying the tax now while their tax brackets are lower and before the politicians raise them higher will ensure that they get to keep more of their hard-earned investment.

  7. Learn How Money Works: Our educational system is utterly useless when it comes to preparing kids for one of the most important subjects, which is how money works. Buy them books, pay for personal finance classes, have them sit with your financial adviser, and tell them to always keep three to four months of living expenses in cash (mandatory) because bad things will happen.

  8. Download these Apps: Smartphone apps can help the younger generation start saving today. Mint by Intuit will help manage finances. Acorn will round up all credit card purchases and invests the change in low-cost funds. Have them download both.

  9. 401(k) Loans: In the pantheon of major financial mistakes, taking out a loan against a 401(k) balance reigns supreme. The temptation to tap this account over time should be squashed immediately if it ever surfaces. Barring a major emergency, there is zero upside.

IMPLICATIONS FOR INVESTORS

Markets evolve over time, and what worked for you will not be enough for your grandchildren. Hence, build upon what was taught to you with these additional strategies, and the younger generation will be better off when it comes time for them to retire.

Lastly, pay close attention to the 7th point above because education cannot be stressed enough. I have lost count to the number of extremely wealthy individuals I have met in my career who live in fear every day of losing what they worked so hard to accumulate. Disciplined investing can build a nice nest egg, but true financial freedom only comes when one accumulates money without fear of losing it.

The bottom line is that the days of easy retirement planning are over and won’t be returning for a very long time, but you can help kids get on the right track by following these guidelines.

Sincerely,

Mike Sorrentino, CFA
Chief Strategist,
Global Financial Private Capital mikeonmarkets.com

The French Vote & Consequences For the Euro & EU

The French Vote & Consequences For the Euro & EU
International Update
May 2017

A similar sentiment that encouraged British voters to exit the European Union (EU) is now influencing French voters to possibly do the same. A leading candidate, Marine Le Pen, is an advocate of France exiting the EU.

A growing concern in Europe is that a domino effect may take hold as the sentiment to exit the EU spreads to other countries. Upcoming elections in Lithuania, Austria, Netherlands, and Germany may yield additional candidates that also favor an EU exit. Of the 28 EU member countries, France currently has the third largest economy after Germany and the UK, which voted to leave the EU in 2016.

The challenge ever since the euro was introduced to the financial markets in 1999 has been how best to synergize the various cultures and languages entangled throughout the EU. In addition to cultural and social diversity, the EU imposes certain rules and laws on EU member countries and their citizens. The regulations have been considered intrusive and overbearing by several EU members.

A current objectionable mandate by the EU on its members has been the acceptance of immigrants. For years, EU members have honored an open door policy to immigrants fleeing political persecution in their home countries, such as Syria, Afghanistan, and Albania.

With the onslaught of recent terrorist activity and attacks by identified immigrants throughout Europe, a growing anti-immigration sentiment has taken root. Among the countries with considerable inflow of immigrants has been France, whose recent terrorist attacks has influenced French voters to insist on new immigration policies.


Sources: Eurostat, Bloomberg, Reuters

 

Where Trump Tax Cuts Will Help The Most

Fiscal Policy

President Trump’s proposal to cut the corporate tax rate from 35% to 15% could benefit various industries and sectors throughout the country.  U.S. based businesses with a domestic focus would benefit the most including retailers, telecom companies, regional banks, restaurants and health insurers.  Domestic based companies have about a 35% tax because they lack lower overseas operations taxation.  Standard & Poor’s estimates that highly taxed companies could see a 30% increase in after-tax earnings if the top corporate tax rate falls to 15%.

Not only may corporations attain higher profits, but consumers may also enjoy lower prices should some of that profitability be passed on to consumers.

The proposals also include a one-time amnesty rate of 10% for U.S. companies that have an estimated $2 trillion in profits trapped outside the United States.  U.S. companies have been discouraged from bringing these profits back to the U.S. because of the current 35% tax rate. Proceeds from the repatriation of $2 trillion into the economy could result in job creation, manufacturing, and increased dividend payouts for shareholders.

Pass-through businesses stand to see a generous tax reduction under the proposals.  Sole proprietorships, S corporations, limited liability companies (LLCs), and partnerships are considered pass-through businesses.

The proposal has become extremely popular with these entities because they currently employ more than 50 percent of the private sector work force and account for roughly a third of all private sector payroll.


Sources: The Tax Foundation, IRS

 

A Bitter Rivalry

Global Financial Capital
Though for the Week

SYNOPSIS

  • Yale University’s endowment returns have crushed the competition over the last 25 years.
  • Alternative investments are those that are not considered to be traditional investments such as stocks, bonds, and cash.
  • Yale can attribute its stellar performance to its large allocation to alternative investments.

BRAGGING RIGHTS

The Ivy League comprises some of the most prestigious educational institutions in the world. Names like Harvard, Princeton, and Yale conjure up images of future world leaders studying relentlessly to achieve perfect marks.  This is a group of high achievers who are unfamiliar with the concept of “second place,” and they fiercely compete  to be the best at everything.  To this cohort, it’s either the  gold medal or nothing at all, and this even extends to  the performance of their school’s endowment fund.

An endowment is critical to the financial stability of a university because the returns fill the gap between revenue (tuition, etc.) and spending (salaries, etc.).  The more money the endowment generates each year, the more a school can pay to attract better professors, build state-of-the-art facilities, and support research endeavors.

Therefore, endowments are closely followed, but no two schools receive more attention than Harvard and Yale.  This bitter rivalry is the investment equivalent of Ohio State and Michigan, Yankees and Redsox, or even Jimmy Connors and John McEnroe.

The table below compares the average annualized returns of Harvard, Yale, and other endowments to all active balanced mutual funds and an indexed 60% stock/40% bond portfolio. The returns clearly show that Yale’s bragging rights over Harvard have been in full effect for decades. When compared to the rest of the competition, it’s not even close. Yale’s returns are so far above all others that it begs the question of how they have been able to do it. 

AN ALTERNATIVE APPROACH

Any real estate agent will say that the three most important rules of real estate are (1) location, (2) location, and (3) location, because the neighborhood determines most the value of a home. Buy a bad house in a great neighborhood, and you should still do ok.

Similarly, the three most important rules in investment management are (1) asset allocation, (2) asset allocation, and (3) asset allocation. Picking the right allocation explains 93% of long-term returns1, and Yale has done a phenomenal job finding the best neighborhoods.

The chart shows the neighborhoods that Yale’s endowment fund selected last year.  

Source: Yale Daily News

Source: Yale Daily News

Two striking conclusions are evident:

  1. Few Stocks & Bonds:  Yale’s allocation to traditional asset classes is tiny. Only 18% is invested in stocks (4% domestic and 14% foreign) and 8% in bonds and cash.
  2. Lots of Others:  Asset classes not classified as either a stock or bond (red-dotted box) comprises 74% of the asset allocation.

Those other asset classes are commonly referred to as “alternative investments” because they are not considered to be equity or fixed income investments. Without question, these are the drivers of Yale’s massive outperformance.

Screen Shot 2017-05-22 at 3.33.47 PM.png

Now that drivers of Yale’s returns have been identified, let’s go under the hood to see why these asset classes have done so well. The chart below lists three different portfolios based on risk tolerance and compares the risk/return characteristics of each over the last 25 years.  

The conservative portfolio consists of 30% stocks and 70% bonds, the moderate is a 50/50 split between the two, and the aggressive is 70% stocks and 30% bonds. As expected, the conservative portfolio has less risk than the aggressive one but also lower returns over time.

However, when each of these portfolios is adjusted to hold a 50% allocation to alternative investments, all three portfolios benefitted from higher returns and less risk (indicated by the three red arrows).

The reason why we see higher returns comes from the sophistication represented by these alternative strategies. These managers tend to fish in different ponds than traditional stock and bond managers, and their expertise often leads to (1) larger returns over time and (2) a smoother ride for investors.

Risk is lower because these asset classes are often less affected from what tends to drive stock prices down. This increased diversification creates tremendous benefits for those investors who prefer a smoother ride over time.

Simply put, Yale’s large allocation to alternative investments is the reason why their returns have far surpassed its competition and the traditional 60/40 portfolio.

IMPLICATIONS FOR INVESTORS

Access to alternative investments has historically been restricted to institutions and ultra-high net worth investors. Fortunately, these barriers have started to fall, and individuals are now able to invest in these assets just as pension funds and endowments have for decades.

The big hurdle that remains for most individuals to invest in alternatives is perception. Thanks to
the financial media, these investments carry a negative connotation as being riskier than traditional investments in stocks and bonds.

Arguably the most egregious of misconceptions is the hedge fund industry. These investment firms employ complex investment strategies to profit across the entire business cycle or mitigate specific risks. They are run by some of the best and brightest investment managers on the planet, and the table below shows that the industry returns far surpassed the S&P 500 from 1998 – 2012, with around half the annual volatility.

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The Sharpe ratio in the far-right column is a measure of efficiency. It divides the excess return above risk-free investments by the annual volatility to measure how much return a manager is generating per unit of risk. A higher Sharpe ratio indicates a more efficient manager, and this hedge fund index delivered 3.6 times more efficient returns than the S&P 500 over this period.

However, since the financial crisis, the media has attacked the hedge fund industry over perceived lackluster returns, fee structures, and large bonuses paid to a select group of high-profile managers. It is as if we cannot go a week without hearing about how some hedge fund has closed or a pension fund fired another manager. The onslaught by the financial media has been relentless.

These stories do nothing but harm individual investors because they paint a picture of hedge funds being the Wild West of the investment world. Nothing could be further from the truth for three reasons:

1. Smoother Ride: Hedge funds aim to deliver more efficient returns, and in doing so tend to give investors a smoother ride over time. Less volatility leads to fewer sleepless nights.

2. Talent: Hedge funds often pay better than traditional asset managers because the strategies are more sophisticated and require the best talent. The intellectual brainpower in many of these firms rival NASA far more than the gunslingers at the O.K. Corral.

3. The Name: Hedge funds get their name because their goal almost always involves hedging some form of risk. Large institutions are not run by incompetent managers, and they would never pay the fees charged by hedge funds unless they were doing their job.

The chart below quantifies the importance of these characteristics by comparing the recovery rate needed to break even for a well-regarded hedge fund index during the financial crisis to the S&P 500.

Since the hedge fund index fell significantly less during the financial crisis, the amount needed to recover was a fraction what the S&P 500 needed to return to get back to even.

Add it all up and individual investors can learn a lot from watching what Yale and other top performing institutions are doing with their money. The level of responsibility that these endowments carry is tremendous, and the notion that some of the most experienced investors overseeing hundreds of billions in assets would gamble away the financial future of the universities they represent is hard to envision.

The bottom line is that Yale University has generated stellar returns over time because those who manage their endowment chose to fish in a different pond than most others, and it is time for investors of all risk tolerances to consider dipping their toes in this water.

 

Consumer Credit Card Debt Hits $1 Trillion

Consumer Finance

As consumer confidence has risen over the past couple of years, so has the appeal to hold debt. Federal Reserve data shows that U.S. consumers now have over $1 trillion on credit cards alone, up 6.2% from a year ago, and is currently the highest amount of consumer credit card debt since January 2009.

 
 

The recent data makes credit card debt the third largest consumer lending category in the industry following auto loans and student loans.

Two variables that economists look at closely are employment and interest rates, which directly affect the ability for consumers to borrow. Economists believe that loosening underwriting standards in various loan categories along with a strengthening employment market could very well offset any interest rate increases.

The credit card business remains among the most profitable in banking as banks can charge much higher interest rates than other loan types, with average credit card rates between 12% and 14%.

Yet, as credit card debt levels have risen, so have reserves for losses as banks anticipate delinquencies to rise. Financially savvy consumers that pay their balances down each month avoid hefty interest charges, but those that don’t, known as “revolvers,” pay average rates of between 12% to 14% and significantly more if they are considered higher risk.


Sources: Federal Reserve

Fixed Income Update

Global Bond Markets

Analysts believe that demographical factors are increasingly influencing the direction of fixed income markets. Even after the fed raised rates this past quarter, along with a series of rate increase expectations, bond yields have reversed and headed lower. The 10-year U.S. Treasury Bond yield fell in April to 2.29%, levels last reached in November 2016.

Volume of investment grade bonds has surpassed the volume of high yield bonds for the first time since 2008, suggesting that sentiment about risk factors in the bond markets may be changing.

An exit from any one of the EU member countries is expected to cause additional negative sentiment and market repercussions in European credit markets as the euro becomes that much more susceptible.

Government bonds from Venezuela reached yields in excess of 20%, as the country bristles with political and economic chaos. It is estimated that Venezuela has roughly $10 billion left in reserves, which is expected to be exhausted fairly soon.


Sources: Reuters, Bloomberg, U.S. Treasury

A Favorite U.S. Export For Foreigners

International Trade

As foreign imports come into question with possible tariffs, certain US exports continue to be in big demand worldwide.

As much as Americans enjoy inexpensive foreign imports, many foreigners enjoy expensive American made products.

U.S. wine makes its way primarily to the UK, Canada, Japan, and Italy, while American beer is most popular in Chile, Australia, Canada, Sweden, and Mexico. U.S. whiskey has become an absolute favorite in Japan, Spain, Australia, and Germany.


Sources: Census Bureau, Distilled Spirits Council of the US

National Parks Contribute Over $34 Billion To Economy

Federal Programs

 
 

As the summer months approach, the National Parks are a destination for tourists all over the United States.  National Parks are part of the National Park Service, which was established in 1916 by President Woodrow Wilson.  Beginning with Yellowstone National Park in Montana and Wyoming, there are 417 parks today covering 84 million acres.

On a recent visit to California’s National Parks, newly appointed Interior Secretary Ryan Zinke made mention of the tremendous activity and economic output the National Park Service is generating. The parks operate under the exclusive control of the Secretary of the Interior.  The 417 parks saw a record 331 million visitors in 2016, contributing $34.9 billion to the U.S. economy.  The economic output is derived from various jobs and industries including lodging, hospitality, retail, transportation, food, fuel, camping fees, and recreational activities.


Sources: U.S. National Park Service

Trump Tax Proposals

Fiscal Policy

The administration of President Trump released its tax proposals in late April. The proposals did vary somewhat from initial proposals presented during the campaign, but adhered to the basic principals of tax reform of broadening the tax base while lowering tax rates.

Markets are anxious because it may take months before there is an indication whether any portion of the tax proposals actually convert into tax legislative law.

Administration officials stated that the reduction in tax revenue generated by the tax cut proposals would be offset through a combination of anticipated economic growth and various broadening measures.

Once the Budget Proposal for Fiscal Year 2018 is submitted by the White House in mid-May, then Congress will begin the deliberation process of the tax proposals.

Affecting most every taxpayer in the country is the standard deduction. The proposal essentially doubles the standard deduction from its current levels, thus simplifying the entire tax process for many tax filers. This is so because the standard deduction is used instead of itemizing expenses in various categories. The Tax Policy Center estimates that those who itemize would fall from 30% to 5%, hence spending less time on identifying expenses to deduct and less of a burden on the IRS.

Ironically, one of the proposals actually hinders homeowners that have expensive homes, primarily in Democratic California and New York. Senators from both states are expected to rebuff the elimination of the state and local property tax deduction, seen as a significant deduction for residents of these expensive coastal states.


Sources:  whitehouse.gov, Tax Policy Center

The Tax Benefits Of Homeownership May Change

Tax Planning

As President Trump’s tax proposals are being unveiled, homeowners are carefully following the possible effects on home ownership. The current tax code provides a number of benefits for taxpayers that own their homes rather than rent. Homeowners have the ability to deduct both mortgage interest and property tax payments from their federal income tax. The possibility of eliminating the deduction of property tax payments may alter the benefits of home ownership for some.

The tax code also allows for the exclusion of capital gains on home sales. Currently the exclusion from taxable income on the appreciation of homes when sold is $250,000 for individuals and $500,000 for joint filers. In order for the exclusion to be effective, the homeowner must live in the home as their principal residence for two of the preceding five years. In addition, homeowners may not have claimed the capital gains exclusion for the sale of another home during the previous two years.

The benefit of property tax and mortgage interest deductions as well as capital gains exclusions tend to benefit higher income earners more. The deductions and exclusions available to all homeowners are essentially worth more to taxpayers in the higher income tax brackets than those in lower income tax brackets.

The difference results largely from various factors: compared with lower income homeowners, those with higher incomes face a higher marginal tax rate and typically pay more mortgage interest and property taxes. They are also more likely to itemize deductions on their tax returns rather than just taking the standard deduction.

Sources: Tax Policy Center, IRS

Reasons to be Bullish

First Trust
Monday Morning Outlook

Brian S. Wesbury – Chief Economist
Robert Stein, CFA – Dep. Chief Economist
Strider Elass – Economist

We wish we had a dollar for every time we’ve heard that the bull market in equities is only due to loose money. We have consistently disagreed, arguing that although the Federal Reserve is loose, the bull market is primarily a function of the rebound in profits after the disaster in 2008-09.

The government’s economy-wide measure of profits – the one’s it releases with the GDP reports – was $2.15 trillion at an annual rate in the fourth quarter of 2016, up 9.3% from the prior year and very close to a record high. In turn, given the strong statistical link between the S&P measure of profits and the government’s measure, as well as the robust gains in S&P profits reported so far for the first quarter, we wouldn’t be surprised at all if the economy-wide measure of profits is hitting a record high in Q1.

The gains in profits are a testament to the enduring ability of entrepreneurs in the face of what has been a bipartisan movement toward more government involvement in the economy dating back to the latter couple of years of the Clinton Administration. These include more government spending, new entitlements, and much heavier regulation.

Now it looks like government policy stands a solid chance of becoming a tailwind to growth rather than a headwind, with less regulation on the energy sector paired with respectable prospects for major reforms of Medicaid and Obamacare as well as supply-side tax cuts.

These changes will sustain the growth of corporate profits even in the face of an acceleration of wage gains as the unemployment rate declines. Notice the lack of a negative equity reaction to Wednesday’s Fed statement that sent a clear signal a June rate hike was on the way. Supply-side policies are the way policymakers can break through the Keynesian mindset that labor and capital have to battle it out for the upper hand and that a “tight” labor market must mean weakening profits.

Meanwhile, it looks like France, and, in turn, the EU can continue on a bullish path. Emmanuel Macron, France’s incoming president, has proposed curbs on France’s wealth tax, wants to decentralize corporate bargaining with unions, plans to cut the corporate tax rate to 25% from 33%, and wants to reduce government jobs (through attrition).

The European Union is in dire need of economic reform, to move toward free-market capitalism rather than (democratic) socialism. But the best way to do this is for major countries in the EU, like France, to reform their economies themselves. If some countries move toward freer markets, other countries will have to follow or capital will move toward more freedom, leaving the others behind. Now it looks like one of those countries is on its way.


Consensus forecasts come from Bloomberg. This report was prepared by First Trust Advisors L. P., and reflects the current opinion of the authors. It is based upon sources and data believed to be accurate and reliable. Opinions and forward looking statements expressed are subject to change without notice. This information does not constitute a solicitation or an offer to buy or sell any security.

Protecting Against Pilot Error

Global Financial Capitol
Thought for the Week

SYNOPSIS

  • A survey conducted back in 2015 indicated that 37% fear the stock market and 73% equate buying equities to gambling.
  • Given the events that have transpired in equity markets since the late 1990s, it is understandable to hear that investors feel that the stock market is rigged.
  • Hiring a professional and proper diversification are two ways to avoid costly mistakes

FEAR AND DISTRUST

I flew back to New York City last week and encountered turbulence on the descent towards LaGuardia Airport.  As the plane made its way to the gate, I noticed that the woman next to me was in tears and shaking uncontrollably.  After she calmed down a bit, we began talking and came to learn that she was just a nervous flyer.

The experience reminded me of a survey I read back in 2015, which questioned over 1,200 Americans what scares them the most. At the top of the list were the usual suspects, with 46% fearing death and 49% being afraid of heights (1).

Equities were not far behind, with 37% of respondents fearing the stock market. Furthermore, around 73% consider investing in the stock market to be a form of gambling, and 31% believe that the stock market is rigged (1).

The reasons for investor fears are not overly surprising, as respondents cited the perceived high risks involved. Common responses included, “I’m afraid of losing money,” and, “I don’t have time to watch the market.” Others stated that they don’t trust someone else making investment decisions for them.

Let’s address these concerns one-by-one. First, in no way whatsoever is the stock market rigged. The U.S. equity market is much too large to be manipulated to the point where only a select few profit on a consistent basis.

Second, the stock market is absolutely used as a casino by day traders. Attempting to profit from short-term price movements is no different than rolling dice down a craps table. In fact, it is arguably even more difficult to day trade because it requires a gambler to be right twice – when to buy and then when to sell – on each trade.

However, those investors who focus on the fundamentals of companies and ignore the day-today market movements are not gambling. They are developing an investment thesis and observing its progress over a multi-year period.

The difference may appear to be subtle, but rest assured the two strategies couldn’t be more different. Regarding the “fear” component of the market, the chart below shows the return on the S&P 500 compared to gold, which is often cited as a “safe haven” asset, from 1980 through March 31, 2017.

Even through the madness of the dot-com bubble and the financial crisis, stocks have generated over 2,090%, which is 14 times larger than gold’s 143% return. Furthermore, gold has never paid a dividend, bought back shares, or engaged in any other shareholder friendly activity. It has just sat there like a shiny pet rock, while the S&P 500 has created tremendous wealth for patient investors.

Gold’s paltry return sheds light into the irony of most “safe” assets. Although they may make an investor sleep well at night, their inability to generate attractive returns over time could pose far greater risk to meeting financial objectives than the stock market ever could.

Hence, some may claim that fear of stock ownership is irrational, but I find it to be no different than the nervous flyer sitting next to me.  Consider the following:

  • Bad Events Resonate:  Even though plane crashes are extremely rare, people often perceive air travel as dangerous. The same goes for equities in the sense that fraud and financial crises rarely occur, but when they do they can resonate for decades.
  • Giving Up Control is Scary:  If you have no experience as a pilot, would you ever get in a cockpit?  The same applies to the stock market, so don’t try to do it yourself unless you have the proper training and logged years of experience.
  • Real Risks Aren’t Obvious:  Although turbulence (aka “volatility”) is how most passengers gauge the safety of a flight, pilot error is almost always the cause for crashes. The same goes for managing equity portfolios. Either making aggressive moves and/or panicking in challenging times is a sure path to suboptimal outcomes.

This passenger even admitted to knowing the statistics around flying. She understood the odds of bad things happening were infinitesimally small, but the data provided no comfort. This came as no surprise because during moments of extreme emotional stress, applying logic and reasoning is akin to bringing a knife to a gun fight.

Regarding the survey, I doubt that there is a single respondent who would listen to reason when it feels like their entire net worth is heading to zero. Hence, whether it is rational or not for some to fear the stock market is irrelevant. All that can be done is to best position this cohort to protect themselves against pilot error.

IMPLICATIONS FOR INVESTORS

The chart below shows the relationship between the number of securities in a portfolio (horizontal axis) and the overall risk of the portfolio (vertical axis – “variance” is a fancy word for a measure of risk).

 
 

This chart explains why diversification is so critical. As the number of securities increases, the risk decreases dramatically. If an investor owns 5 stocks and one is in a company that commits fraud, then 20% of the portfolio is exposed to this risk. By owning 50 stocks, only 2% of the portfolio is at risk. Furthermore, while a single stock can go to zero due to several reasons, properly diversified portfolios cannot.

Maintain diversification through economic booms and busts, and an investor should not have to stay up at night wondering when the next Enron or Bernie Madoff will happen. There’s no question that another crisis will occur down the road. These events will catch headlines and boost financial news network ratings just as they have in the past, but timing them is impossible and any attempt to try will only cause more harm than good.

Rather than play a guessing game, I prefer to invest in diversified portfolios that contain built-in protection. This approach takes the timing and risk of pilot error out of the equation.

The bottom line is that a professionally managed, well-diversified portfolio is the best way to help investors cope with their fear of the stock market.

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Global Financial Private Capital, is an SEC registered investment adviser principally located in Sarasota, Florida. Investment Advisory Services offered on a fee basis through Global Financial Private Capital, LLC. Securities offered through GF Investment Services, LLC, Member FINRA/SIPC. SEC registration does not imply a level of skill or training.

Help Your Student Protect Themselves

Sending your son or daughter off to college can be very nerve racking for Moms and Dads.  Across the country there is a feeling of vulnerability that a lot of parents experience as they say good bye to having their kids safe and sound under their roofs.  Nevertheless, the college experience simultaneously allows students to begin experiencing more freedoms including managing their time, their finances, and their responsibilities. 

All of these new experiences are an essential part of the maturation process; but they provide greater opportunities for problems as well.  Many times these problems can arise from simple naivety and exposure to things they have never faced before.  There are some steps that Mom and Dad can take to reduce the likelihood their son or daughter will find themselves dealing with issues that can distract them from their studies or, worse yet, haunt them for many years beyond college.

ID theft is a multibillion dollar problem worldwide, and even the most cautious of individuals can be suspect to it.  For a relatively small annual fee, you can get credit fraud protection that will notify you any time there is activity on your credit report.  An unsuspecting 18 year old can be a prime target for these types of thieves to grab their identity and cause major damage before you have any clue.  A regular check of their credit coupled with some protection will go a long way to reducing the chances of this happening.

Going off to college and having a social life that includes eating out, going out with friends, taking weekend trips, going to concerts, and attending games creates memories that will often last a lifetime.  But many times these things come fast and furious and students don’t have the experience to properly manage all these choices or, more importantly, the cost of these choices very well.  Providing your new college student with smaller balances that get replenished more frequently is often a good way to oversee how they are doing on a regular basis.  Ask your student to keep a record and provide you a report of expenses prior to receiving their next installment of funds.

College can be a good time to begin establishing some credit history.  Work with your bank to get your son or daughter a credit card with a $500 to $1500 balance that you have online access to.  Talk with your kids about how the card should be used.  Most importantly, put them in charge of paying it off each month.  These are lesson that are better learned now under your supervision than in a few years when you have no control or access.

As parents we are hopeful that college is a gateway to a successful and productive life for our grown children.  However, all of the learning that will lead to their success doesn’t always take place in the classroom.  Help your kids avoid the financial pitfalls that so many Americans fall into because they just didn’t have the financial education to know better.

Everett Wealth Solutions, Inc. is in the business of helping families through the major life transition of sending their children to college.  For many, it will be the most expensive time of their lives and, if not handled properly, could cost them their retirement.  If you or someone you know needs the help and guidance of a trained financial professional, don’t hesitate to contact Chris Everett, your local College Planning Relief® Licensee.

Remember, you shouldn’t have to choose between your child’s college and your retirement.