The Emerging Gap

8/19/16

By Michael McKeown, CFA, CPA - Chief Investment Officer

Despite the high stock prices and a great run in bond prices, investors can hardly be described as exuberant.  Perhaps it is because they look at the investment landscape and do not see much that they like. 

Bond yields fell from 15.75% in 1981 to 1.51% today (see below).

By definition, this yield is the expected return on a risk-free 10-year Treasury bond held to maturity.  It is tough to get excited about these yields as well as meeting financial planning objectives.

It is easy to argue that stocks are priced above fair value.  Price-to-sales, price-to-earnings, price-to-cash flow – all traditional ways to measure relative value – are well above their historical medians.

After looking at these ideas, people are throwing up their hands and asking, “what is the alternative?” 

We look at the world a little differently.  The first rule of investing?  Buy low, sell high.  Where have prices been low for a while?  It is emerging markets.

Historically, there are 5 to 7 year cycles where emerging markets and developed markets take turns leading. The U.S. won the ebb and flow recently.  The S&P 500 dramatically outperformed emerging markets by 98% in the last five years.   

Signs of a change in this trend are evident.

As has happened in most cycles, the U.S. dollar peaked right around the first interest rate hike.  One of the largest detractors from returns over the last few years for emerging markets has actually been their currencies, rather than just share prices.  Currency markets have turned around since February of 2016. 

Prices bottomed at 10% lower than in the 2002 bear market, making them a great value 14 years later. 

Earnings are also turning the corner, with the fastest six-month growth rate since 2011.

Finally, inflation is coming under control.  In Brazil, inflation was at 10.7% just a year ago and it has since fallen to 8.7%.  India also stabilized its inflation rate in the 5 to 6% range.  Price stability is an important attribute for countries to display for investors.

So what are the alternatives?  While U.S. stocks prices are high, our favorite stocks are in emerging markets. With lower valuations on both share prices and currencies, emerging market equities look appealing.  This is apparent as emerging markets outperformed the U.S. by 8% in 2016.  Considering the strong demographic and productivity trends, along with lower overall debt levels compared to developed markets, emerging markets have many tailwinds.

 

This material is based on public information as of the specified date, and may be stale thereafter. Aurum Wealth Management Group and/or Aurum Advisory Services has no obligation to provide updated information on the securities or information mentioned herein. Actual events may differ from those assumed and changes to any assumptions may have a material impact on any projections or estimates.

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Politicians Changing Attitude toward Debt

7/28/16

By Michael McKeown, CFA, CPA - Chief Investment Officer

It was only a few years ago that people from both sides of the aisle in Congress were calling for austerity.  The same went for members of the ECB and politicians in Germany and the UK.  All across the globe cutting debt was the way to prosperity.

It turns out those policies were wrong.

Perhaps ‘wrong’ is too harsh a term.  'Poorly timed' given the economic situation, may be more descriptive.

Countries are changing their approach when it comes to debt.  This may be due to the rise of populist political movements or growth that is not what it used to be.  In July, several countries announced plans to expand spending.

  • A 60 billion Canadian dollar fiscal stimulus plan was unveiled by Justin Trudeau, including infrastructure spending.  This equates to 3% of GDP.
  • 20 trillion yen stimulus package including projects for high speed rail and infrastructure (including loan and guarantees) was introduced.  This equates to 4% of GDP.
  • UK’s Philip Hammond, Chancellor of the Exchequer, indicated a possible stimulus package this autumn to counter the negative effects of the vote to leave the European Union.

"The US is doing better than the rest not because its quantitative easing worked better, but because it is the only country with a central bank that openly argued against fiscal austerity."  This quote is from Richard Koo, Chief Economist from the Nomura Research Institute. He is one of the few economists to witness and live through Japan’s 20 years of quantitative easing.  In addition, he correctly diagnosed the balance sheet problems for the nation.

The U.S. indeed turned out to be the least austere, despite some people actively campaigning for it.  This turned out to be the correct policy.  Why? Households were deleveraging and corporations not investing.  A government deficit was necessary to fill the gap left by households and corporations.  It is a big reason why the U.S. is the only country out of the 4 major economic blocs to not battle deflation over the last year.

The chart above shows the inflation rates across the developed world.  The U.S. topped Europe, Japan, and the UK at 1% over the last year.

Both of the major parties' Presidential candidates this fall both support greater spending.  The fiscal spending impulse could result in higher inflation.  In turn, this could cause bond investors to want more compensation for inflation risks.  This would cause yields to rise and bond prices to fall.

Just like greater fiscal spending, rising bond yields go against the trend of the last several years.  A rise in U.S. bond yields over the next year or two, does not mean a secular change is ahead.  Other factors, such as the yields offered by global bond markets and growth trends, will determine the path of interest rates.

Adding to the short-term risk of a rising bond yields is the positioning of real money traders.  Commercial traders have the largest bet against bonds since early 2013 (just before the Taper Tantrum when yields spiked).  In contrast, small traders have the largest bet on bonds in four years, which is usually a contrarian indicator.

The chart above shows that the U.S. 2-year Treasury note yields far above Japan and Europe.  Thankfully, it is in positive territory.

Based on the data presented, and compared to the rest of the world, America is not doing that bad.

 

This material is based on public information as of the specified date, and may be stale thereafter. Aurum Wealth Management Group and/or Aurum Advisory Services has no obligation to provide updated information on the securities or information mentioned herein. Actual events may differ from those assumed and changes to any assumptions may have a material impact on any projections or estimates.

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Brexit Breakdown

6/24/16

By Michael McKeown, CFA, CPA - Chief Investment Officer

After four decades as a member, on Thursday, voters in the U.K. voted to leave the European Union.  It was a close vote, 52% for “Leave” to 48% for "Stay."  This means that the long-standing trade and immigration agreements that covers 28 countries will no longer apply to Great Britain after its official exit.  The majority of citizens clearly felt that EU membership was inhibiting growth and prosperity.

Currencies and stock markets fell around the globe on Friday as votes were tallied the previous night.  Europe was obviously hit the hardest by sellers as the uncertainty about other countries potentially leaving the bloc and the economic outlook gets murkier.

The demographic split among the vote is getting attention as the ‘older’ generation voted to leave and ‘younger’ voted to stay in the EU. But the London-based Financial Times went further and explained:

“As the votes were counted on Thursday night and Friday morning, the piles of ballot papers told their own story about those parts of Britain that felt comfortable in a modern, connected world, and those which felt cut off from the fruits of globalisation.

Voters in London and Scotland, the two most prosperous parts of the UK, turned out in large numbers to deliver a clear message that they wanted to remain in the EU and its huge single market.

But elsewhere — in the old industrial centres of the north, the small towns of the Midlands and the faded seaside resorts — the ballot papers were stacked high in favour of Leave, rejection of an establishment that had let them down.”

Politics… well, we won’t touch that here, but suffice it to say the environment could be better and it is a sign that populists' leanings across other countries have momentum.  This is a headline risk to the economy and markets, but it does not always mean there will be fundamental changes to either.

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“This will end badly.”

This is pretty much the phrase at least one person says concerning any headline risk in the financial world right now… low interest rates, the U.S. dollar, China, the Middle East, venture-backed technology companies being overvalued, oil prices… Brexit.

But what if it doesn’t?

Exhibit A – Japan.

Yes, the country has negative interest rates, its society is very old with poor demographic trends, and its stock market has shown signs of life but is no higher than where it was in 1989.  But by and large – the standard of living improved incredibly over the last couple of decades and its nominal growth was positive on average.

In the U.S., the unemployment rate is low.  Inflation is also low.  Growth is lower than in the past, but it is still positive and at the same trend of the last few years. Still, the stock market is near all-time highs and bond investors enjoyed great returns the last couple of years. 

Everyone in Cleveland is seeing things a little rosier today thanks to the Cavaliers winning an NBA championship (though in my defense, I began drafting this note two weeks ago).

There is always an event in the financial news merry-go-round to bring out the pessimists.  Nonetheless, the term “Secular Stagnation” is being thrown around by ‘top’ economists to describe the disappointing output level, implying it is simply fate that we are at a permanently lower plateau.  Perhaps it is an inopportune time to have a pro-cyclical view but being an optimist paid off over the very long term – for the lowly economists and investors alike.

In terms of portfolios, we came into the Brexit vote tactically underweight international equities, meaning the allocation was below the long-term strategic target.  Morgan Stanley Research believes there is approximately 15-20% downside risk to European equities, which we would view as an opportunity to buy international stocks and rebalance to equalweight or back to the strategic targets.

 

This material is based on public information as of the specified date, and may be stale thereafter. Aurum Wealth Management Group and/or Aurum Advisory Services has no obligation to provide updated information on the securities or information mentioned herein. Actual events may differ from those assumed and changes to any assumptions may have a material impact on any projections or estimates.

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The Mortgage Rate Vortex

6/10/2016

By Michael McKeown, CFA, CPA - Chief Investment Officer

Interest rates are nearing the lowest level in three years.  While we discussed what this means for future returns on the asset side of the balance sheet, it is an advantage on the debt side.

In many ways, mortgages are the tail that wags the interest rate dog.  If interest rates rise too fast, it can hurt the housing market, which the Fed certainly does not want to see.  When interest rates fall though, it allows homeowners to refinance mortgages to lower interest rates, assuming enough home equity is there.  It also creates a hedging vortex for real-money mortgaged-backed security investors, which can plunge rates even lower. 

The trend in mortgage rates over the last 15 years was down, though not without many zigs and zags.  Today, rates are at the lowest point since early 2013.

15-year term mortgages always offer lower interest rates than a longer 30-year mortgage.  15 years ago, this difference was relatively small; only about 0.4%.  For the debtor, this was a fairly nominal difference.  Today, the difference is approximately 0.75%, which is also a low spread.  But when rates go from 3% to 4%, instead of from 7% to 7.5%, it is important to not only look at not the raw numbers, but also the ratio between 15 and 30-year mortgage rates.  Doing so, one can see a high percentage increase in interest expense.  In addition, we can look at that previous ratio with respect to the 10-year treasury.  As seen below, today’s 30-year mortgage rate is about 23% higher than the 15-year.

Refinancing after interest rates fall gives homeowners the chance to pay down mortgages faster, lower interest rates, and lock in a great return on investment (when considering the extra payment as the ‘investment’ and the reduction of interest the ‘return’). 

Let’s look at an example of a $250,000 mortgage in year one of the term.  Comparing mortgage rates in 2001 to 2016 lets us see how much more valuable a refinancing can be when interest rates are low.  

The annual payments increases by $6,153 but the interest paid drops by $1,233, which goes towards principal.  This results in a 20% return on investment (ROI), which was four times the risk-free rate of return for the 10-year Treasury.

Let’s look at an example using the average conventional mortgage rates today.

With the 30-year at 3.93%, it makes sense to move to a 15-year at 3.20%, though the tradeoff being that the payment goes up nearly 50%.  Still, the interest saved of $1,937 results in a 28% ROI.  Since the 10-year Treasury risk free rate is so low today compared to that ROI, it is that much more valuable to refinance.  One can make 17 times the risk free rate in the above scenario in the first year.  This only increases in subsequent years as the mortgage principal declines at a quicker pace.

The average rate for all outstanding mortgages today in the United States is 4%.  In a hypothetical scenario where 15-year mortgage rates fall to 2.5%, the mortgagee could refinance from the original 30-year term to 15-years.  That is, if the mortgagee is willing to pay a 34% higher mortgage payment per month.  This may sound like a lot, but it is almost matched dollar for dollar by greater principal pay down.  The return on this investment is a whopping 80% per year over the first five years!  Moreover, assuming the payments are always made, it is a guaranteed return – well worth it in any interest rate environment.

In light of the negative interest rates from Japan to Europe hitting record lows, we will be watching in the months ahead to see if the downtrend in U.S. interest rates continues to create another wave of refinancing activity.  Mortgagees should be ready to pounce (and go through the painful refinancing process of pulling documents), but just think about that return on investment and it is well worth it.

 

This material is based on public information as of the specified date, and may be stale thereafter. Aurum Wealth Management Group and/or Aurum Advisory Services has no obligation to provide updated information on the securities or information mentioned herein. Actual events may differ from those assumed and changes to any assumptions may have a material impact on any projections or estimates.

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Back Door Roth IRA: How To Avoid The IRA Aggregation And Step Doctrine Rules

 

05/27/2016

By Michael Baker, CFP® - Manager of Financial Planning

With the passage of the Protecting Americans from Tax Hikes Act of 2015 Congress re-enacted numerous tax-planning provisions including state and local sales tax deductions, the American Opportunity Tax Credit, and rules allowing for qualified charitable distributions directly from an IRA to a charity for those over age 70½. What we don’t see in the legislation is any mention of the “Back door Roth strategy.” With this in mind, high-income individuals who aren’t eligible to contribute to a Roth IRA in the traditional manner are—at least for one more year—permitted to do a Roth conversion.

IRS rules prohibit contributions to a Roth IRA for individuals with an annual adjusted gross income (AGI) of $131,000 ($193,000 for married couples). This does not preclude these individuals from contributing to a traditional IRA, though the deductibility of these contributions will vary depending on whether they participate in an employer-sponsored retirement plan. Under the Internal Revenue Code, as adjusted by the Protecting Americans from Tax Hikes Act of 2015, there are no income restrictions on Roth conversions. Consequently, anybody who funds a traditional IRA, whether it’s pre-tax or after-tax, is able to convert that traditional IRA to a Roth IRA.

Taken together, those with higher income may not be allowed to make Roth IRA contributions, but there is nothing precluding them from sneaking in the “back door” by converting an after-tax traditional IRA to a Roth IRA. Of course there are several rules that stand between high-income individuals and a successful use of this strategy.

While the “back door” strategy is fairly straight forward, there are rules that can slam that door shut if the execution of the strategy is not buttoned up. Internal Revenue Code Section 408(d)(2) relates to what is known as the IRA aggregation rule. This rule states that for any individual with multiple IRAs the total value of all of those IRAs will be considered when calculating the tax consequences of any distributions from an IRA (including distributions for a Roth IRA).

Often times IRAs contain dollars that haven’t been taxed; for instance, an IRA rollover from an old 401(k) plan. When this is the case, and these pre-tax IRAs are aggregated with the new after-tax IRA, the distribution for a Roth conversion will be treated as made on a pro-rata basis from the multiple accounts. The net result in such cases is that some of those dollars will be taxed even if they are distributed exclusively from an after-tax IRA!

Example: John has $450,000 of existing IRA assets, accumulated by rolling over 401(k) accounts from former employers. John’s income exceeds the IRS limits for making a contribution to a Roth IRA, but wishes to make a $5,500 contribution to a non-deductible IRA and convert only the $5,500 from the newly established IRA into a Roth IRA.

Due to the IRA aggregation rule, John is not permitted to convert only the $5,500 non-deductible IRA contribution. He must treat the $5,500 conversion from any account as a partial conversion of all of his IRA assets.

With this in mind, if completes a $5,500 Roth conversion, the after tax portion of that conversion will only total $5,500 / $455,500 = 1.21%. The net result of his $5,500 Roth conversion will be $66.42 of after-tax funds that are converted, meaning that $5,433.58 of the conversion will be taxable to John!

After the conversion is completed, John will be left with a $5,500 Roth IRA and $450,000 of pre-tax IRAs that still have $5,433.58 of associated after-tax contributions (the remaining portion of the $5,500 non-deductible contributions that were not converted).

While the aggregation rule considers all IRAs (excluding inherited IRAs) it does not include employer retirement plans (401(k), 403(b), etc.). The fact that these employer plans aren’t included in the aggregation rules once again cracks open the back door. Many—though not all—401(k) plans provide the option to roll over assets into the plan. In such cases, pre-tax IRAs can be rolled into an employer retirement account, thus removing the assets from the aggregation equation. Suddenly all that remains from an aggregation standpoint is the new after-tax IRA.

The second consideration when it comes potential problems with the back door IRA strategy is what is known as the “step transaction doctrine.” The premise behind this is simple, the Tax Court is considering the intention not the process. Accordingly, if the contribution to an after-tax IRA is done simultaneously with the conversion of that IRA to a Roth IRA, what really happened in the Tax Court’s view was nothing more than a contribution to a Roth IRA. The Tax Courts ruled unfavorably on this in the 1935 Gregory v. Helvering. If the transactions are done in close succession, and that is determined by the IRS and Tax Court to be solely for the purpose of contributing to a Roth IRA, the individual may be hit with a 6% excess contribution penalty!

In order for the back door Roth IRA strategy to work it is essential that each step of the process is completely legitimate. This can be accomplished by increasing the time between opening the IRA and converting it to a Roth IRA. This gets tricky because there are no hard-and-fast rules on how long is long enough to wait. By establishing the after-tax account in June 2016 and converting it to a Roth in December of 2016 the case that each step served its own purpose can be made easier.

The last, simplest, and most important consideration of all is that there not be any records (personal or financial professional) that indicate any intention of doing a “backdoor Roth IRA.” This will almost certainly slam that back door shut if the Tax Court Comes across it. Communications with and files of your financial professional are discoverable documents in such proceedings!

There is no guarantee that this strategy will continue to be available on an ongoing basis. The presidential election looms large over all things political and financial. If the primaries are any indication of the current state of our political system, it seems that everything is on the table at this point; be it cuts or expansion! In short, strike while the iron is hot!

 

Disclosure: This material is based on public information as of the specified date, and may be stale thereafter. Aurum Wealth Management Group and/or Aurum Advisory Services has no obligation to provide updated information on the securities or information mentioned herein. Actual events may differ from those assumed and changes to any assumptions may have a material impact on any projections or estimates.

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3 Must Know Stories About Today’s Markets

5/27/2016

By Michael McKeown, CFA, CPA - Chief Investment Officer

The summer doldrums are not here for investors.  A few stories and charts tell the big picture about what is moving markets.

We said it before and we’ll say it again - housing is back.  After building too many houses in the 2000s and not enough in the early 2010s, we are almost back to the long-term average for new home sales (see white dash lined below).  April’s data came in at a seasonally adjusted annual rate of 619,000, which is the highest since January 2008.  Existing home sales have long since recovered, but new homes being built creates much more economic production.

Oil prices nearly doubled from just three months ago.  In February, crude oil hit $26/barrel and tagged $49/barrel this month.  As oil goes, so goes gasoline prices at the pump.  In Cleveland, average gas prices bottomed at $1.628 and now stand at $2.363.  The tax cut consumers received at the pump went away somewhat, but consumer sales (excluding building materials, autos, gas, and food) were up 3.6% over the past year, which is a solid pace of growth for this cycle.

Often people talk about the market without digging into the next layer of description, sectors.  Even within sectors there is so much diversity in businesses, regulations, and, of course, value!  Below we look at the history of price to earnings (P/E) ratios across sectors as a crude measure of value.  This gives a base measure of what is priced at a premium or discount compared to its own history and the market.  As a point of reference, the global market P/E is at 17 today.  Investors are clearly pricing in positive prospsects for the energy sector, which sports the highest P/E ratio of 25.  This is followed by consumer staples (perceived to be ‘safer,’ perhaps) and healthcare.  On the low end are financials at a 12 P/E ratio, which many believe will turn into more of a utility because of the increased regulation, low interest rates, and lack of growth.  Ironically, the second cheapest sector is utilities at 15.5.

Between housing, oil, and value differences across sectors, there are plenty of themes to grab investors’ attention.

 

This material is based on public information as of the specified date, and may be stale thereafter. Aurum Wealth Management Group and/or Aurum Advisory Services has no obligation to provide updated information on the securities or information mentioned herein. Actual events may differ from those assumed and changes to any assumptions may have a material impact on any projections or estimates

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The Investor Dilemma

5/5/2016

By Michael McKeown, CFA, CPA - Chief Investment Officer

My first job started when I was about seven or eight years old.  Mrs. Penner, our neighbor across the street, would pay me $1 each week to take out her trash cans to the street and then back to the garage the next day.  She would also bake our family homemade rolls on occasion.  My great grandparents lived in the same house before my parents and knew the Penners well, who lived on the same street since the early 1900s.

Mrs. Penner was tough, growing up in the depression and in Youngstown through its steel boom and its slow demise.  The house was considered a mansion when it was built and was more than twice as big as any on the street, with ivy growing up the sides.  It had been turned into a two unit house and one day, the little boy who lived in the upstairs unit was locked out.  He told Mrs. Penner his woes after she pulled into the driveway.  Her simple reply, “Tough luck, kid.”  And she shut the door behind her.

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It is a phrase that my family said to me many times growing up and still half-jokingly uses as a response to my nephew when he cannot get his way or in approaching tough circumstances.

If she was alive today, Mrs. Penner probably would not have much sympathy for investors and asset allocators, even though interest rates were five times higher back then! 

Government bond yields today are at the lowest levels since the 1950s.  Here is a chart of yield ranges for the last ten years in light blue and the current yields in red.

The Barclays Aggregate Bond Index yields 2.1% and intermediate municipal bond portfolios yield 1.5%.  Stepping up the credit risk to corporate high yield and emerging market bonds offers greater return but also increased risk. 

Turning to stocks, many markets around the world look at above average valuations across several measures.  Interest rates clearly have an affect on price-to-earnings ratios (P/E), yet they were low for most of the last ten-years.  The chart below shows the ten-year range of P/E ratios across 23 countries and where each stands currently.

The U.S. stock market trades at a multiple of 17.3 times its forward earnings estimate, near the top end of its ten-year range. This is at a time when earnings are flatlining for companies.  Towards the bottom of the chart we can see many markets considered riskier such as Taiwan and Brazil trading below the ten-year average. 

The equity returns from these levels are not likely to be annualized at 10% per annum going forward as they have historically.  More likely are results in the mid-single digit range over the next seven to ten years.  That says nothing of the variability that one can see on a one or two year basis, where returns have a much wider distribution.

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Howard Marks, the founder and CEO of Oaktree, a $100 billion investment manager,  writes excellent memos discussing risk, return, pyschology, and the choices investors face.  One of his memos neatly sums up the investor dilemma in a section titled Prudent Behavior in a Low-Return World

“The possibilities [for investors] fell into just a few categories: 

  • Go to cash – not a real alternative for most investors.
  • Ignore the lowness of absolute returns and pursue the best relative returns.
  • Forget that elevated prices might imply a correction, and buy for the long run.
  • Reach for return, going out further on the risk curve in pursuit of returns that used to be available with greater safety.
  • Concentrate investments in “special niches and special people”; by this I meant emphasizing strategies offering exceptional bargains and managers with enough skill to wring value-added returns from assets of moderate riskiness.

Of all of these, I consider reaching for return to be the most flawed, especially if it’s done without being fully conscious (which is often the case when return becomes hard to come by).  I’ve described this approach as “insisting on achieving high returns in a low-return world” and reminded people of Peter Bernstein’s admonition: “The market’s not a very accommodating machine; it won’t provide high returns just because you need them.” 

None of these possible solutions is perfect and without pitfalls.  In fact, each brings its own form of risk.  Staying safe entails the risk of inadequate return.  Reaching for return increases the risk of financial loss.  And the search for “alpha” managers introduces the risk of choosing the wrong ones.  But, as the say, “it is what it is.”  When its a low-return world, there are no easy solutions devoid of downside.”

He wrote this five years ago in May 2011 and while asset prices are higher, the message remains relevant.

The silver lining with the lower nominal expectations for asset returns going forward is that inflation has been historically low, so real (or inflation-adjusted returns) are not so bad on a relative basis.  While we can complain to the Fed about holding interest rates too low or the high stock prices, I already know what Mrs. Penner would say, “Tough luck, kid.”

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In Mrs. Penner's defense, she finished smoking her cigarette, gave the kid a cookie, and let him inside.

 

This material is based on public information as of the specified date, and may be stale thereafter. Aurum Wealth Management Group and/or Aurum Advisory Services has no obligation to provide updated information on the securities or information mentioned herein. Actual events may differ from those assumed and changes to any assumptions may have a material impact on any projections or estimates.

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What State Economies Tell Us About the Country

4/28/2016

By Michael McKeown, CFA, CPA - Chief Investment Officer

Whenever people talk about the “U.S. economy” in broad terms, we can forget how diverse the industries and regions are in this vast land.  The Federal Reserve Bank of Philadelphia publishes an index every month for all 50 states to provide a gauge of where growth stands today and where it points in the months ahead.  The Leading Index takes into account employment, manufacturing, housing permits, and interest rates.  We will look to see what this data shows us about economic conditions today and if we can draw any parallels to the past.

Let’s start with looking at how many states out of 50 show expansion.  The graphic below shows the total count on the vertical axis with time on the horizontal axis.  Only four times in its history have less than 40 states been positive – 1982, 1986, 1990, 2001, and 2008.  The only one of these years that did not contain a recession was 1986.

Today, 45 states show expansion with Tennessee and Nevada at the highest levels.  On the other end, just slightly in negative territory is Iowa followed by Louisiana, North Dakota, West Virginia, and Wyoming.

Next, we have five states chosen for the size and differences in their economies, including California, whose $2.4 trillion in economic output is roughly the same size as France.  Here is how the Leading Index for each state grew and contracted over time.

The dip in the above chart in 1986 from both Texas and North Dakota were from the oil price shock that year, when prices fell 61% in just a few months.  Over-supply drove prices down, rather than less demand from end consumers and businesses.  This is similar to the situation today, where fracking in the U.S. and continued pumping from abroad led the supply of oil to overwhelm the price, thus pushing it from $115 per barrel in June 2014 to $27 per barrel in January 2016 to about $45 per barrel today.

In the first quarter, markets worried that the oil price fall was indicating a demand problem.  Our friends at Guggenheim coined the phrase, “The Great Recession Scare of 2016,” which may end up sticking as demand seems to be in good shape.  The states showing negative data have economies reliant upon the energy sector – North Dakota, Wyoming, West Virginia – so the supply shock idea holds weight, while the most other states continue to do well.

Let’s look at where most of readership comes from, Ohio.  Ranking 7th in the country in terms of Gross Domestic Product, the Ohio economy produced just shy of $600 billion in economic activity in 2015.  The Coincident Economic Index tells us where the economy stands today using changes in employment, hours worked, and wages/salary growth. 

This index grew at 3.2% over the last year, down from the cycle peak of 4.9% in 2012, but still a fairly healthy clip.  Given Ohio’s diverse economic engines from manufacturing, healthcare, financial services, energy, and education – it is a nice gauge and currently shows expansion.

States with economies reliant upon the energy sector are feeling the pinch from lower commodity prices, but if oil keeps going up or holds steady, this will help.  Otherwise, most states are chugging along nicely.

 

This material is based on public information as of the specified date, and may be stale thereafter. Aurum Wealth Management Group and/or Aurum Advisory Services has no obligation to provide updated information on the securities or information mentioned herein. Actual events may differ from those assumed and changes to any assumptions may have a material impact on any projections or estimates.

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King Dollar Gets Dethroned

3/30/2016

By Michael McKeown, CFA, CPA - Chief Investment Officer

We are less than a month away from the new season of Game of Thrones (!). One of the most exciting aspects of the show is the unpredictability and that what you think is going to happen, hardly every does.  Once someone gets momentum for sitting on the iron throne, the writers throw the viewers a curve ball.

In a way, the moves in currency markets are similar.  The one way street higher in the dollar from 2011 to 2015 seems to be meeting a speed bump.  It is not what markets anticipated with the Federal Reserve being the only central bank in the world to embark on a hiking cycle at this point, but that is what makes the markets (and the story) interesting.

In the last 30 years, there were four previous hiking cycles and we just entered the fifth this past December.  In previous cycles, the U.S. dollar index tended to rally in the months preceding the first interest rate hike, followed by the dollar falling in the two years after the first rate hike (the exception being 1999).

So far, the dollar index is sticking to the playbook.   Expectations for the hiking cycle were fully baked into the currency when the Fed hiked the fed funds rate on December 15th.  The dollar is down 5% since then.

Assets with foreign currency denomination will be a place for opportunity if the dollar continues its fall.  Below we show the MSCI Emerging Markets Index denominated in the U.S. dollar and local currency.  Because the dollar appreciated against emerging market currencies, the MSCI EM Dollar Index underperformed by 25% the last five years.  As can be seen in the bottom graphic in pink fuchsia, this underperformance flattened out and ended in January.  Since then, emerging market currencies made up ground lost to the dollar.

The high correlation of the dollar and other risk assets (from equities to commodities) seems to be fading.  Traders and analysts continue to discuss the silent 'quid pro quo' among central bankers, that is, to stop with the currency wars as the strong dollar hurts global exports.  In her speech yesterday, Fed Chair Janet Yellen expressed concern over the global economy and how a fast pace of rate hikes could do more damage.  In turn, the dollar continued to tumble, so this will be important to watch as the hiking cycle continues. 

Which currency will take the throne?  It may not be the one that everybody thinks.

 

This material is based on public information as of the specified date, and may be stale thereafter. Aurum Wealth Management Group and/or Aurum Advisory Services has no obligation to provide updated information on the securities or information mentioned herein. Actual events may differ from those assumed and changes to any assumptions may have a material impact on any projections or estimates.

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The Global Market Portfolio

3/11/2016

By Michael McKeown, CFA, CPA - Chief Investment Officer

Every few years, authors of the Financial Analysts Journal update a version of the global multi-asset market portfolio.  It considers the total market value of investable assets in the world.  I made some tweaks since the article seems to understate some large asset classes like private equity and real estate.  This provides a framework for analyzing where your portfolio weights compare to a passive version of the world.

Even Nobel Prize winner William Sharpe stated that he “cannot easily understand why funds do not routinely compare their asset allocation with current market proportions.”

We will start with the big picture.  The total value of investable assets is $179 TRILLION, yes with a “T.”  Of that, public equities make up $66 trillion, fixed income securities $93 trillion, real estate $17 trillion, and private equity/venture capital at $3 trillion.  All figures are estimated as of the year-end 2015.

For my purposes, I excluded hedge funds as these are a vehicle to mainly access equity, fixed income, and derivative securities.  At a quite relevant $2.7 trillion, the argument can be made for inclusion, but this would result in double counting a large portion of assets since actual holdings are largely traditional equities and bonds, with leverage.  I also excluded commodities because historically this “asset class” provides a 0% real return with massive volatility (which is worse than cash, over time).  I went back and forth on excluding the $6.6 trillion of negative yielding global bonds as well, but kept them since perhaps one day the yields will be positive and investable again.

Below we have a breakdown of each asset class with regions and sub-asset classes.

The U.S. is still the biggest public equity market, but with Japan and China so large, the Asia Pacific Region is larger than the EMEA region (Europe, Middle East, & Africa).  The surprising items from going through this exercise was how much developed market debt there is outside of the U.S.  It is the largest asset class and sadly the yields are mostly below 2%.  I also was surprised at the size of the U.S. single family rental market, which is an emerging asset class for institutions.  The measly size of private equity was interesting considering all of the media attention.

Here is a look at the values above but presented in proportion to one another as the next level look of the Global Market Portfolio.

Whether an individual or institutional investor, one’s asset allocation will have some difference to the Global Market Portfolio.  The time horizon, liabilities, overall objectives, and risk tolerances all play a factor on whether the right design is overweight equity and underweight fixed income, for example.  Still, it serves as a gauge of where one falls on the spectrum for areas such as Mortgage Backed Securities (MBS) or Investment Grade Corporate bonds.

We think of having more than a benchmark as being “overweight” an asset and less than a benchmark as being “underweight.”  Arguably, the most common overweight positions for external portfolios we review are in U.S. Equity (14% of Global Market Portfolio), U.S. High Yield Corporate bonds (1%), and MLPs (0.2%). 

The most common underweights are to a few areas which I do not mind, since the foreign currency exposure would be too costly to hedge. This includes developed market fixed income and emerging market fixed income (though a modest allocation is surely appropriate).  Most also tend to be underweight real estate (since one’s home rarely is cash flow positive even if it is paid off, I cannot classify this as an “investment).  In addition, most hold an underweight to foreign equities (both developed and emerging, which make up 23% of investable assets).

Where does your portfolio stand relative to the Global Market Portfolio?

 

Sources: Securities Industry and Financial Markets Association, World Federation of Exchanges 2015 Report, Norway Sovereign Wealth Fund Real Estate Study 2015, Prequin, JPMorgan Guide to the Markets, Morgan Stanley Research

This material is based on public information as of the specified date, and may be stale thereafter. Aurum Wealth Management Group and/or Aurum Advisory Services has no obligation to provide updated information on the securities or information mentioned herein. Actual events may differ from those assumed and changes to any assumptions may have a material impact on any projections or estimates.

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