Monthly Path Toward Prosperity -April 2018

SENTIMENT SHIFT
Is Tech now evil?


WHAT IS LIBOR?
Should I care?


IS THIS WHAT A BUBBLE LOOKS LIKE?
Should I care?


SUMMARY OF INVESTMENT THEMES

SENTIMENT SHIFT

It seems clear to me that sentiment within areas of the investing world has begun to shift.  Previously, in "big data" or "big tech" it seemed as if they could do no wrong.  For basically the last decade, many of the large, growing technology-based companies have experienced expanding revenue growth, expanding valuations and elevating stock prices.

But recently, it seems as if the public and investing sentiment against toward those companies has changed.  Facebook was recently caught in the crosshairs of both public and political blowback due to the potential mismanagement of the data it has collected about us.  CEO, Mark Zuckerberg was recently called to testify before Congress about the sanctity of the data it collects about each of its users.

According to Grant Williams, fifty million people is the number of Facebook users whose private information Cambridge Analytica harvested in improper fashion via an App called thisisyourdigitallife.  As of Wednesday, April 4th, it was reported that number is now 87,000,000!

The app was downloaded by 270,000 people and when they logged in to take a personality test, the App asked them to click that simple blue button...That button (so you don't have to input your email, name and all the other stuff) gave Cambridge access to not only their personal data but also all the data on any friends of theirs!  That is due to a tweak in the terms of service back in 2015.  The data included photos, interests, locations, status updates, check-ins, and likes.  That is a lot of data on American voters.

How often, do you download a new App and it asks you to log-in via Facebook?  Each time you allow that, more data is being collected about what you do and how you do it.  For really the first time in the company's existence, the public has really begun to wonder what is being done with the data it collects and more importantly, who exactly has access to that data.

Have you ever taken one of the personality surveys on Facebook?  Have you taken a quiz about what celebrity you would look like?  What "Friends" character you are most like?  All of these quizzes are designed to get you to interact and to gather data about you.

It seems as if the public has finally said, "No Mas!"  For those who are interested, there is a way for you to see exactly what data Facebook has about you.  It isn't advertised.  However, this is how you do it.

Go to your Facebook Settings and click on “Download a copy of your data” at the bottom of the page. Facebook needs a little time to compile all that information, but it should be ready in about 10 minutes.  You’ll receive a notification sending you to a page where you can download the data—after re-entering your account password, of course.

The (likely huge) file downloads onto your computer as a ZIP. Once you extract it, open the new folder and click on the “index.html” to view the data in your browser.

Other big tech, data companies have come under further scrutiny as it seems people now want to know more about who knows what about them.  This is a great discussion to have but may limit the ability for these companies to grow.  It is possible this is one of those "moments".  As I said, sentiment may have shifted.  The belief that no price is too high to pay for those companies dealing with big data and artificial intelligence may be over.

Back in October of 2017, writer, Peter Atwater, wrote the following...

Tech Giants, Once Seen as Saviors, are now Viewed as Threats

The FANG bubble peaked in July – just three months ago – and already we are seeing this kind of criticism. Just wait. As confidence drops further, this headline will seem kind...

With some very minor tweaking, I could easily recast and apply these same thoughts to Harvey Weinstein. Powerful, overconfident men are about to face a similar backlash – and not just in the media. Again, the worst simply go first.

Bullies are like prison wardens; they require perceptions of complete omnipotence to retain their power. The slightest weakness leads to complete collapse. A prison environment is binary: total control or no control - omnipotence or impotence...

For now, though, the important take away for the week is this: Whether in corporate or individual form, the behaviors associated with chronic overconfidence are being exposed at an accelerating, soon to be alarming, pace. Where trust has been violated, the price to be paid will be extreme.

We’ve now entered “The Backlash Era.”

If Peter is correct in his thinking, the valuations of these companies will need to be adjusted downward.

 

WHAT IS LIBOR AND WHY SHOULD I CARE?

LIBOR stands for the London Interbank Offered Rate.  LIBOR is a benchmark interest rate used on everything from mortgages, to credit card rates to student loan rates.  It's important to know the direction of LIBOR because any debt with an adjustable interest rate tied to it will be impacted when it moves.

LIBOR after literally doing nothing from 2009 to 2015 is now at a 9.5 year High.  Granted that is still only 2.36% as of late April but it has moved quite a bit recently.  Check out the following charts.

  

I am always on the lookout for items in the global economy that might not be paid much attention but have changed trend.  This is a trend that clearly changed over two years ago but has recently accelerated.  What I think is important to know is that, according to Bloomberg, roughly $350 trillion of derivatives and loans are linked to the Libor rate.  That is a TON of debt tied to this rate.  Interest costs just rose substantially, which is why following this rate is important.  There are all kinds of reasons being tossed out for why this is occurring because the media has to have some reason for its change. The point is that in roughly 24 months, this rate has quadrupled!

What does that mean for your portfolio?  That is yet to be determined and probably unknowable.  What is important to note is that monetary conditions around the world continue to tighten.  It is becoming harder to access capital, and the rates needed to lend money out are much higher than they were even a year ago.  That may put additional stress on global growth and is becoming a headwind that may impact market valuations.

If one of the reasons that stock market valuations have remained elevated is the low-interest rates that global central banks have engineered, then one may surmise that increasing interest rates may have the impact of lowering market valuations through asset price declines.

 

ARE WE IN A U.S. STOCK BUBBLE? SHOULD WE CARE? WHAT CAN WE DO?

Many of you reading this newsletter have heard the following quote somewhere.

"The market can stay irrational longer than you can stay solvent."

U.S. stock valuations now exceed all historical valuation levels, except for those hit in the peak of the dot-com mania.  Is the U.S. stock market in a bubble?  Before answering that question, we must first have agreement on what constitutes a bubble?  I would prefer to keep this as simple as possible because we can go down a rabbit hole with no end.

Let's use Research Affiliates founder Rob Arnott's definition of a bubble.  A bubble has a couple characteristics.  First, a particular asset class or sector that is experiencing a bubble has prices that have risen to levels above either historical norms or its intrinsic value, or both, and peaked.  Therefore, these investments should have little chance of returning more than bonds or cash while using any reasonable projection of future cash flows.  (Meaning, the asset is at least fully valued.)

Second, the asset's price is sustained because investors have a belief that they can sell the asset to someone else for a higher price in the future without regard to the underlying fundamentals of the asset.  Third, in order to be in a bubble, we need to strongly believe the definition applies.  Close doesn't count.

Many academics will say that bubbles cannot exist.  They would say that for every buyer there is a seller and because some buyers would purchase an asset at the prevailing price, the market must be efficient.  I would say efficient yes, rational no.

The efficient market hypotheses may be stretched to fit market behavior by allowing for variations in the amount of risk that participants are willing to take at a given time.  In this view, high valuations don't represent mispricing; the risk just happens to be sufficiently low so as to justify the prices.

I, personally, would disagree with this analysis.  Vernon Smith won the Nobel Prize for his work that showed how bubbles and crashes occur more frequently than we would like throughout normal economic settings.  Even though investors do share the same information, the way that information is processed allows for investors to come to different conclusions about the data.

Recency bias is a very strong investor trait that may contribute to the formation of bubbles and subsequent crashes.  A study by Greenwood and Shleifer (2013) shows how investors believe future returns will be very similar to the recent past.  After periods of strong returns, investors have strong beliefs that the good times will continue.  After poor returns, investors believe poor returns will continue.

As of January this year, 7 of the top ten largest cap stocks in the world were technology companies: Alibaba, Alphabet (formerly Google), Amazon, Apple, Facebook, Microsoft and Tencent.

According to Arnott, history has shown that on average, just two stocks from the top 10 global market capitalization stocks remain on the same list a decade later. I don't like those odds.

Further, as shown in previous newsletters, with sentiment toward investing in stocks near or at all-time highs according to many surveys, the two components seem to be there.

What do you do if you believe we are in a United States stock bubble?  Here are two things you can do if you believe we are in a United States stock bubble.

First, you can choose to avoid or at least limit exposure to the overvalued areas of the market.  By reducing exposure to assets whose valuations are substantially higher than historical norms, one can reduce the potential risk in the portfolio.  Of course that also means underperforming the broad market if a bubble keeps inflating.

Second, you can seek out investments that are not in bubble territory.  The arguments as to why valuations in the United States are not in a bubble also apply to the European and Emerging stock markets, but valuations are generally 50% cheaper than somestic stocks according to Mr. Arnott.

Both of these adjustments could reduce your risk toward bubbly assets while maintaining a growth-oriented trajectory to your equity portfolio allocation.  According to Mr. Arnott and Resarch Affiliates, from March 2000- March 2002 as the technology bubble popped, the S&P 500 was down 23.4%....on its way to a 49% decline just six months later.  However, the average U.S. stock rose 7.0% over that same time frame.  The lesson being, one doesn't have to be completely in or out of the stock market to avoid a bubble.  One just has to look objectively and tilt toward areas of better value.

As we stand now, in the United States, value stocks are much cheaper than growth-oriented stocks and this is even truer when you look internationally.  If investors reduce equity allocations away from traditional market cap weighted exposures like the S&P 500 toward value-based strategies with a global focus, they may be more apt to avoid a 2000 like scenario in the next eventual market downturn.

 

 

INVESTMENT IDEAS

  • Rather than trying to “beat the market”, focus on beating inflation and the rate on cash.  Plan for safety and liquidity while seeking positive returns.

 

  • Equity valuations are very rich but masked due to the distortion of the Treasury curve. Volatility is returning to the markets and I think long/short managers are best positioned to capture this volatility by owning companies with strong businesses, barriers to entry, and good valuations and selling short weaker companies with high debt loads that have risen sharply with the broad market rally. I think this strategy of hedged equity may have the potential to produce attractive risk-adjusted returns if and when investors begin to question the valuations of companies. Stock investing involves risk including loss of principal. No strategy ensures success or protects against a loss. Long positions may decline as short positions rise, thereby accelerating potential losses to the investor.

 

  • Monsoon country investments. Attempting to take advantage of demographic, educational and investment possibilities in the countries surrounding the old spice routes of the Indian Ocean. International investing involves special risks such as currency fluctuation and political instability and may not be suitable for all investors. These risks are often heightened for investments in emerging markets.

 

  • A potential U.S. infrastructure upgrade cycle may be around the corner. Moving from our current grade of D+ to B would require an investment of $3.6 trillion by 2020.

 

  • Supply problems remain high across the energy asset class. While there isn’t a current shortage of energy on the planet, it is taking more and more energy and capital to discover, drill, transport and refine it. Long term Demand should continue to grow globally, particularly in China, India, and other developing countries.

 

  • Potential food shortages due to inclement weather and higher demand from the emerging Asian middle class could result in a boon to agricultural land and potash fertilizer companies. International and emerging market investing involves special risks such as currency fluctuation and political instability and may not be suitable for all investors.

 

  • The rise of E-Commerce has coincided with an increased desire for efficient warehouse distribution real estate. As e-commerce moves toward even faster delivery, positioning of distribution becomes even more important.

 

  • Precious metals mining companies have been extremely beaten down over the past four years. Mining is an industry that spans hundreds of years. Companies that mine for commodities are often highly cyclical, meaning they have sustained moves both up and down. When investing in the mining space it is important to be a contrarian. Ideally, you would want to accumulate miners when sentiment is poor around them and sell them when sentiment is positive. Historically this has been a good strategy.

 

No strategy ensures success or protects against a loss.

If you haven’t followed me on LinkedIn make sure to connect with me. Since the beginning of the year, I have been a contributor to many major investment publications and it has been great getting to know some of the writers.

 

Check out my appearances by clicking here

 

 

Regards,

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Colin B. Exelby
President
Celestial Wealth Management


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